Modifications of Debt Instruments

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8675]

RIN 1545-AR04

Modifications of Debt Instruments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

modification of debt instruments. The regulations govern when a

modification is treated as an exchange of the original debt instrument

for a modified instrument. The regulations provide needed guidance to

issuers and holders of debt instruments.

DATES: These regulations are effective September 24, 1996.

For dates of applicability of these regulations, see Sec. 1.1001-

3(h).

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

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On December 2, 1992, proposed amendments to 26 CFR part 1 were

published in the Federal Register (57 FR 57034) to provide guidance

under Sec. 1.1001-3. The proposed regulations relate to the

modification of debt instruments. On February 17, 1993, the IRS held a

public hearing on the proposed regulations. In addition, the IRS

received numerous written comments on the proposed regulations. The

proposed regulations, with certain changes made in response to

comments, are adopted in this Treasury decision as final regulations.

The principal changes to the regulations, as well as the major comments

and suggestions, are discussed below.

Explanation of Provisions

A. General

The preamble to the proposed regulations states that the proposed

[[Page 32927]]

regulations are intended to address the uncertainty concerning when the

modification of a debt instrument results in a deemed exchange of the

old debt instrument for a new instrument. Some of this uncertainty

resulted from the possible impact of the decision of the Supreme Court

in Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991). The

preamble invites comments with respect to whether it is desirable to

provide rules for the modification of debt instruments as well as

comments with respect to what those rules should be.

Although the IRS received many comments on the proposed

regulations, relatively few commentators addressed the question of

whether regulations on the modification of debt instruments are

desirable. A few commentators argued against the promulgation of

regulations on this subject. A number of other commentators were

supportive of the attempt to provide certainty through a series of

specific rules. Some commentators suggested that the regulations adopt

a facts and circumstances approach with safe harbors under which

certain modifications would not be treated as exchanges. In contrast,

other commentators suggested using additional bright-line rules to

provide more certainty with respect to when a modification is, and is

not, treated as an exchange of the old debt instrument for a new

instrument. Most commentators, however, limited their comments to the

specific rules of the proposed regulations.

The IRS and Treasury considered adopting a single, general rule

instead of several detailed rules. That approach, while providing less

guidance, would have the advantage of reducing complexity and avoiding

anomalies that can result from bright-line rules (for example,

different results for economically similar transactions). Nevertheless,

after considering that approach the IRS and Treasury concluded that

both taxpayers and the IRS would benefit from regulations specifically

addressing the treatment of certain modifications. A debt modification

that results in an exchange may have a variety of consequences, and

parties contemplating a change to a debt instrument should be able to

determine whether that change will result in an exchange.

Accordingly, the final regulations retain the basic structure of

the proposed regulations. Thus, an alteration of the terms of a debt

instrument is first tested to determine whether the alteration is a

``modification.'' If there is a modification, the modification is then

tested to determine whether it is a ``significant modification.'' A

significant modification results in an exchange of the original debt

instrument for a modified instrument that differs materially either in

kind or in extent within the meaning of Sec. 1.1001-1(a).

Although the final regulations generally follow the approach of the

proposed regulations, certain rules have been added or modified to

address a number of issues noted by commentators. For example, in one

instance the final regulations provide a general rule with respect to a

particular type of modification together with a safe harbor for certain

changes that will not result in exchanges. In other instances, the

final regulations retain the bright-line approach of the proposed

regulations. The IRS and Treasury invite comments on the operation of

the final regulations and will consider providing additional guidance

as appropriate.

B. Other Instruments

In the preamble to the proposed regulations, the IRS invites

comments with respect to whether the regulations should be expanded to

address modifications of financial instruments other than debt

instruments. In response, several commentators argued that a dealer's

assignment of its position in an interest rate swap contract or other

notional principal contract should not result in an exchange under

section 1001 for the nonassigning counterparty. In response to these

comments, the IRS and Treasury are issuing proposed and temporary

regulations that provide a special rule for dealer assignments of

notional principal contracts. However, those temporary and proposed

regulations and these final regulations do not address whether

particular instruments are debt instruments for Federal income tax

purposes.

With the exception of those temporary and proposed regulations, the

final regulations have not been expanded to cover the modification of

financial instruments other than debt instruments. The modification of

other instruments is less common than the modification of debt

instruments, and the rules for modifications of debt instruments would

not necessarily work well or be appropriate in determining whether

modifications of other instruments result in exchanges under section

1001. For equity instruments in particular, the IRS and Treasury

believe that the application of certain rules in these regulations

would be inappropriate. Similarly, for contracts that are not debt

instruments, the final regulations do not limit or otherwise affect the

application of the ``fundamental change'' concept articulated in Rev.

Rul. 90-109 (1990-2 C.B. 191), in which the IRS concluded that the

exercise by a life insurance policyholder of an option to change the

insured under the policy changed ``the fundamental substance'' of the

contract, and thus was a disposition under section 1001.

C. Modifications

The final regulations retain the general rule of the proposed

regulations that a modification includes any alteration of a legal

right or obligation of the issuer or holder. The final regulations,

however, do not adopt the rule of the proposed regulations that a

unilateral waiver of a right that does not rise to the level of a

settlement of terms between the parties is not a modification of the

original instrument. Commentators noted that it often is impossible to

distinguish between a unilateral waiver of a right and a workout agreed

to by the parties in which only the holder of the instrument makes

meaningful concessions. Moreover, in the case of a prepayable debt

instrument, the holder's waiver of rights may be an inducement to the

obligor not to terminate the debt instrument.

In defining when an alteration is a modification, the final

regulations also generally retain the rule that a change in a term of a

debt instrument that occurs by operation of the terms of a debt

instrument is not a modification. A change may occur by operation of

the terms of an instrument at a specified time, as a result of a

contingency specified in the instrument, or upon the exercise of an

option provided for in the instrument to change a term.

The final regulations limit the application of the rule for changes

that occur by operation of the terms of a debt instrument in three

respects. First, the final regulations retain the rule of the proposed

regulations that any alteration that results in an instrument or

property right that is not debt for federal income tax purposes is a

modification, even if the alteration occurs by operation of the terms

of the instrument (unless the alteration occurs pursuant to a holder's

option under the terms of the instrument to convert the instrument into

equity of the issuer). Second, the final regulations also provide that

any alteration that results in a substitution of a new obligor, the

addition or deletion of a co-obligor, or a change in the recourse

nature of an instrument is a modification. The IRS and Treasury believe

that these changes may be so fundamental that they should be

[[Page 32928]]

considered modifications even if they occur by operation of the terms

of an instrument. Thus, these modifications always must be tested for

significance to determine whether they result in exchanges.

Third, the final regulations provide that alterations resulting

from the exercise of either of two categories of options are

modifications. These two categories of options are (i) those that are

not unilateral (defined essentially in the same manner as in the

proposed regulations) and (ii) holder options the exercise of which

results in a deferral or a reduction in any scheduled payment of

interest or principal. Because alterations resulting from the exercise

of such options typically involve either negotiations between an issuer

and holder or a workout, the IRS and Treasury believe it is appropriate

to treat them as modifications and test for significance. In this

regard, the rule for holder options resulting in deferrals or

reductions of payments addresses more specifically the concerns

underlying the proposed regulations' rule discussed above regarding

unilateral waivers that rise to the level of a settlement of the terms.

Many commentators argued that the proposed regulations are overly

restrictive in recognizing only temporary nonperformance by the issuer

and temporary waivers of default rights by holders as not being

modifications. In particular, commentators expressed concern about an

example in the proposed regulations that illustrates the temporary

waiver rule with a situation in which the waiver is only for a 3-month

period. The IRS and Treasury recognize that parties may need a period

of time to modify the terms of a debt instrument following an issuer's

default and that a holder's waiver or nonenforcement of default rights

may not itself evidence an agreement with respect to new terms.

The final regulations respond to these comments in two respects.

First, the regulations provide that nonperformance by the issuer is

not, in and of itself, a modification. Second, the regulations provide

a limited exception to the rule that a waiver of rights is a

modification. Under this exception, absent an actual written or oral

agreement by the issuer and the holder to alter other terms of the

instrument, an agreement by the holder to stay collection or

temporarily waive an acceleration clause or similar default right is

not a modification for a period of two years following the issuer's

nonperformance, or for a longer period (after the initial two-year

period) during which the parties conduct good faith negotiations or

during the pendency of bankruptcy proceedings. Once the parties agree

to new terms, however, there is a modification of the instrument.

As under the proposed regulations, a modification is tested when

the parties agree to a change even if the change is not immediately

effective, but the final regulations add exceptions for a change in a

term that is agreed to by the parties but is subject to reasonable

closing conditions or that occurs as a result of bankruptcy

proceedings. In these cases, a modification occurs on the date the

change in the term becomes effective. Thus, if the conditions do not

occur (and the change in the term does not become effective), a

modification does not occur.

D. Significant Modifications

The final regulations retain the structure of the proposed

regulations for determining whether a modification is significant, but

change a number of the specific rules for particular types of

modifications. The final regulations also add a new general rule for

types of modifications for which specific rules are not provided. Under

this general rule (the general significance rule), a modification is

significant if, based on all the facts and circumstances, the legal

rights or obligations being changed and the degree to which they are

being changed are economically significant.

The general significance rule also applies to a type of

modification for which specific rules are provided if the modification

is effective upon the occurrence of a substantial contingency.

Moreover, the general significance rule will apply for certain types of

modifications that are effective on a substantially deferred basis.

When testing a modification under the general significance rule, all

modifications made to the instrument (other than those for which

specific bright-line rules are provided) are considered collectively.

Thus, a series of related modifications, each of which independently is

not significant under the general significance rule, may together

constitute a significant modification.

With the addition of the general significance rule, certain

specific rules of the proposed regulations have not been included in

the final regulations. For example, under the proposed regulations,

whether the addition or deletion of a put or call right is a

significant modification depends on the value of the put or call. The

significance of an alteration of a put or call right depends on whether

the alteration significantly affects the value of the right. The

proposed regulations provide similar rules for the addition, deletion,

or alteration of a conversion or exchange right. Under the proposed

regulations, certain changes in the types of payments under a debt

instrument (for example, a change from a fixed rate debt instrument to

a variable rate or contingent payment debt instrument) are significant

modifications. These rules have not been included in the final

regulations because the general significance rule provides adequate

guidance.

For changes in the yield of a debt instrument, the final

regulations provide that a change in yield is significant if the change

exceeds the greater of 25 basis points or five percent of the original

yield on the instrument. This rule was modified in response to comments

that a change of more than 25 basis points should be permitted in the

case of debt instruments issued with high interest rates. The final

regulations also limit this change-of-yield bright-line rule to fixed

rate and variable rate debt instruments. Because of the difficulties in

developing appropriate mechanisms for measuring changes in the yield of

other debt instruments (for example, contingent payment debt

instruments), the final regulations provide that the significance of

changes in the yield of those other instruments is determined under the

general significance rule. The final regulations also incorporate other

technical changes to clarify the application of the change-in-yield

rules.

The final regulations do not adopt the suggestion of some

commentators that a reduction in the principal amount of a debt

instrument should not be considered a modification. As under the

proposed regulations, for purposes of determining if there is a

significant modification, the yield on the modified instrument is

computed by reference to the adjusted issue price immediately before

the modification. A reduction in principal reduces the total payments

on the modified instrument and often results in a significantly reduced

yield on the instrument. Thus, these rules give the same weight to

changes in the principal amount as to changes in the interest payments.

The IRS and Treasury believe that the tax consequences of a change in

the yield that results from a change in the amounts payable should not

differ because of the characterization of the payments that are reduced

as principal rather than interest.

For changes in the timing of payments (including any resulting

change in the amount of payments), the proposed regulations contain a

rule that an extension of the final maturity of an instrument for the

lesser of five years or

[[Page 32929]]

50 percent of the original term of the instrument is not a significant

modification. Any other change in the timing of payments is subject to

two rules. Under the first rule, any material deferral of payments is a

significant modification. Under the second rule, any change in terms

designed to avoid the application of the rules for original issue

discount is a significant modification. Commentators objected to both

of these rules because they do not provide bright-line rules for

determining whether a modification is significant. In addition, the

commentators argued that an example in the proposed regulations that

concerns the deferral of interim payments is inconsistent with the rule

for an extension of final maturity.

The final regulations combine the rules for extensions of final

maturity and other changes in the timing and/or amounts of payments.

While adopting the material deferral rule generally, the final

regulations also allow the deferral of payments within a safe-harbor

period (the lesser of five years or 50 percent of the original term of

the instrument) if the deferred amounts are unconditionally payable at

the end of that period. The final regulations do not contain the rule

that the Commissioner may treat any deferral of payments made with a

principal purpose of avoiding the time value of money rules, including

the rules for original issue discount, as a significant modification.

The concerns addressed by this rule in the proposed regulations have

been resolved in final regulations recently issued under section 1275.

See Sec. 1.1275-2(j).

For a change in the obligor on an instrument, the final regulations

retain the general rule in the proposed regulations that changing the

obligor on a recourse debt instrument is significant. In addition to

the exception for section 381(a) transactions in the proposed

regulations, the final regulations include an exception for

transactions in which the new obligor acquires substantially all of the

assets of the original obligor. Each exception must meet two

requirements. First, other than the substitution of a new obligor, the

transaction must not result in any alteration that would be a

significant modification but for the fact that it occurs by operation

of the terms of the instrument. Second, the transaction must not result

in a change in payment expectations. The final regulations also provide

that the substitution of a new obligor on a tax-exempt bond is not a

significant modification if the new obligor is a related entity to the

original obligor and the collateral securing the instrument continues

to include the original collateral.

A change in payment expectations occurs if there is a substantial

enhancement or impairment of the obligor's capacity to meet its payment

obligations under the instrument and the enhancement or impairment

results in a change to an adequate capacity from a speculative capacity

or vice versa. There is no change in payment expectations, however, if

the obligor has at least an adequate capacity to meet its payment

obligations both before and after the modification.

The final regulations also apply the payment expectations test to

determine whether the addition or deletion of a co-obligor is a

significant modification. Similarly, the final regulations provide that

whether certain other modifications are significant is determined by

reference to whether the modifications result in a change in payment

expectations. Those modifications include (i) the release,

substitution, or addition of collateral as security for a recourse

debt, (ii) the addition, deletion, or alteration of a guarantee or

other credit enhancement, and (iii) a change in the priority of a debt

instrument. As under the proposed regulations, a modification that

releases, substitutes, or adds a substantial amount of collateral as

security for a nonrecourse debt instrument is a significant

modification.

A number of commentators raised questions regarding the

circumstances under which the modification of a debt instrument will

require a determination of whether the modified instrument is debt or

equity. Many expressed concern that a deterioration in the financial

condition of the issuer between the date of original issuance and the

date of the modification could lead to a determination that the

modified instrument is not debt for tax purposes. The final regulations

address this concern by providing a rule that for purposes of this

regulation, unless there is a substitution of a new obligor, any

deterioration in the financial condition of the issuer is not

considered in determining whether the modified instrument is properly

characterized as debt.

The final regulations also modify the rules pertaining to the

significance of changes in the method under which payments are

calculated. The proposed regulations provide that a modification is

significant if it results in a change between the categories of fixed

rate, variable rate, and contingent payment instruments or if it

changes the currency in which payment under the debt instrument is

made. The Treasury and the IRS determined that such an approach was

both too broad and too narrow (i.e., certain changes involving

economically insignificant adjustments would be characterized as

significant, while other more economically dramatic changes would not

be characterized as significant). Accordingly, the final regulations do

not provide any bright-line rules so that the significance of any

change in the method under which payments are calculated is determined

under the general significance rule.

The final regulations adopt the rule of the proposed regulations

that a change in the recourse nature of an instrument is a significant

modification, but limit this specific rule to changes from

substantially all recourse to substantially all nonrecourse, or vice

versa. If an instrument is not substantially all recourse or not

substantially all nonrecourse either before or after a modification,

the significance of the modification is determined under the general

significance rule. The final regulations also provide two exceptions.

First, a modification that changes a recourse debt instrument to a

nonrecourse debt instrument is not a significant modification if the

instrument continues to be secured only by the original collateral and

the modification does not result in a change in payment expectations.

Second, a defeasance of a tax-exempt bond permitted by the terms of the

instrument generally is not a significant modification.

E. Rules of Application

The rules of application in the final regulations are similar to

those in the proposed regulations. In general, the final regulations

treat a series of changes of an instrument over time as a single

change. To avoid the need to retain information for all modifications

that affect yield over the life of the debt instrument, however, the

final regulations add a rule that, for changes in the yield,

modifications occurring more than five years earlier are disregarded.

The final regulations do not adopt the suggestion of commentators

that the rules in Sec. 1.1001-3 should not apply to tax- exempt bonds.

These commentators stated that, as a result of an intervening change in

the Internal Revenue Code (Code) or regulations, a significant

modification could result in bonds that were tax-exempt when issued

ceasing to be tax-exempt bonds. Because many changes in the Code and

regulations have been made applicable to refunding bonds, it is

appropriate that changes to outstanding tax-exempt bonds that are, in

substance, the equivalent of

[[Page 32930]]

refundings be treated as such. The IRS and Treasury believe that the

standards used under Sec. 1.1001-3 generally are appropriate for this

purpose.

In response to other comments, a number of changes have been made

to better coordinate the final regulations with municipal financing

practices. The regulations clarify that state and local bonds (other

than those financing conduit loans) are treated as recourse obligations

for purposes of determining whether a modification is significant.

State and local bonds financing conduit loans are nonrecourse only if

there is no recourse to either the actual issuer or the conduit

borrower. In the case of bonds financing conduit loans, the final

regulations clarify that the obligor of a tax-exempt bond is the entity

that issues the bond and not the conduit borrower. The regulations

note, however, that a transaction between a holder of a tax- exempt

bond and a conduit borrower may result in an indirect modification of

the tax-exempt bond.

F. Other Matters

The preamble to the proposed regulations indicates that Notice 88-

130 (1988-2 C.B. 543), which provides special rules for qualified

tender bonds, will continue to apply. The final regulations continue

this approach, and thus do not apply for purposes of determining

whether tax-exempt bonds that are qualified tender bonds are reissued

for purposes of sections 103 and 141 through 150. The IRS and Treasury

are reviewing the rules of Notice 88-130 and intend to issue proposed

regulations on this subject under section 150. When the final

regulations are issued under section 150, the exclusion for qualified

tender bonds in Sec. 1.1001-3 will be revised or eliminated as

appropriate.

Also, as noted in the preamble to the proposed regulations, a

modification of a debt instrument that results in an exchange under

section 1001 does not determine if there has been an exchange or other

disposition of an installment obligation under section 453B. Whether or

not there has been an exchange or other disposition of an installment

obligation is determined under the cases and rulings applicable to

section 453B. Similarly, the fact that an alteration does not

constitute a modification or a significant modification does not

preclude other tax consequences.

Simultaneously with the issuance of these final regulations, the

IRS and Treasury are issuing temporary and proposed regulations under

section 166. Those regulations allow taxpayers, in certain limited

situations, to claim a deduction for a partially worthless debt when

the terms of a debt instrument are modified. Commentators on the

proposed regulations noted that section 166 permits a deduction for a

partially worthless debt only in the year that the taxpayer makes a

partial charge-off for book accounting purposes. A significant

modification of a debt instrument that has been partially charged off

may result in the recognition of gain and an increased tax basis in the

instrument. Because the book charge-off is not reversed, however, the

taxpayer cannot take another charge-off, and thus the taxpayer cannot

meet the requirement for a deduction for a partially worthless debt

under section 166. In this situation, the temporary and proposed

regulations deem the charge-off to have occurred at the time of the

significant modification if certain requirements are met.

Effective Dates

The final regulation applies to alterations of the terms of a debt

instrument on or after September 24, 1996. Taxpayers, however, may rely

on this section for alterations of the terms of a debt instrument after

December 2, 1992, and before September 24, 1996.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information The principal author of these regulations

is Thomas J. Kelly, Office of Assistant Chief Counsel (Financial

Institutions & Products), IRS. However, other personnel from the IRS

and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read

in part as follows:

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

Par. 2. Section 1.1001-3 is added to read as follows:

Sec. 1.1001-3 Modifications of debt instruments.

(a) Scope--(1) In general. This section provides rules for

determining whether a modification of the terms of a debt instrument

results in an exchange for purposes of Sec. 1.1001-1(a). This section

applies to any modification of a debt instrument, regardless of the

form of the modification. For example, this section applies to an

exchange of a new instrument for an existing debt instrument, or to an

amendment of an existing debt instrument. This section also applies to

a modification of a debt instrument that the issuer and holder

accomplish indirectly through one or more transactions with third

parties. This section, however, does not apply to exchanges of debt

instruments between holders.

(2) Qualified tender bonds. This section does not apply for

purposes of determining whether tax-exempt bonds that are qualified

tender bonds are reissued for purposes of sections 103 and 141 through

150.

(b) General rule. For purposes of Sec. 1.1001-1(a), a significant

modification of a debt instrument, within the meaning of this section,

results in an exchange of the original debt instrument for a modified

instrument that differs materially either in kind or in extent. A

modification that is not a significant modification is not an exchange

for purposes of Sec. 1.1001-1(a). Paragraphs (c) and (d) of this

section define the term modification and contain examples illustrating

the application of the rule. Paragraphs (e) and (f) of this section

provide rules for determining when a modification is a significant

modification. Paragraph (g) of this section contains examples

illustrating the application of the rules in paragraphs (e) and (f) of

this section.

(c) Modification defined--(1) In general--(i) Alteration of terms.

A modification means any alteration, including any deletion or

addition, in whole or in part, of a legal right or obligation of the

issuer or a holder of a debt instrument, whether the alteration is

evidenced by an express agreement (oral or written), conduct of the

parties, or otherwise.

(ii) Alterations occurring by operation of the terms of a debt

instrument. Except as provided in paragraph (c)(2) of this section, an

alteration of a legal right or

[[Page 32931]]

obligation that occurs by operation of the terms of a debt instrument

is not a modification. An alteration that occurs by operation of the

terms may occur automatically (for example, an annual resetting of the

interest rate based on the value of an index or a specified increase in

the interest rate if the value of the collateral declines from a

specified level) or may occur as a result of the exercise of an option

provided to an issuer or a holder to change a term of a debt

instrument.

(2) Exceptions. The alterations described in this paragraph (c)(2)

are modifications, even if the alterations occur by operation of the

terms of a debt instrument.

(i) Change in obligor or nature of instrument. An alteration that

results in the substitution of a new obligor, the addition or deletion

of a co-obligor, or a change (in whole or in part) in the recourse

nature of the instrument (from recourse to nonrecourse or from

nonrecourse to recourse) is a modification.

(ii) Property that is not debt. An alteration that results in an

instrument or property right that is not debt for federal income tax

purposes is a modification unless the alteration occurs pursuant to a

holder's option under the terms of the instrument to convert the

instrument into equity of the issuer (notwithstanding paragraph

(c)(2)(iii) of this section).

(iii) Certain alterations resulting from the exercise of an option.

An alteration that results from the exercise of an option provided to

an issuer or a holder to change a term of a debt instrument is a

modification unless--

(A) The option is unilateral (as defined in paragraph (c)(3) of

this section); and

(B) In the case of an option exercisable by a holder, the exercise

of the option does not result in (or, in the case of a variable or

contingent payment, is not reasonably expected to result in) a deferral

of, or a reduction in, any scheduled payment of interest or principal.

(3) Unilateral option. For purposes of this section, an option is

unilateral only if, under the terms of an instrument or under

applicable law--

(i) There does not exist at the time the option is exercised, or as

a result of the exercise, a right of the other party to alter or

terminate the instrument or put the instrument to a person who is

related (within the meaning of section 267(b) or section 707(b)(1)) to

the issuer;

(ii) The exercise of the option does not require the consent or

approval of--

(A) The other party;

(B) A person who is related to that party (within the meaning of

section 267(b) or section 707(b)(1)), whether or not that person is a

party to the instrument; or

(C) A court or arbitrator; and

(iii) The exercise of the option does not require consideration

(other than incidental costs and expenses relating to the exercise of

the option), unless, on the issue date of the instrument, the

consideration is a de minimis amount, a specified amount, or an amount

that is based on a formula that uses objective financial information

(as defined in Sec. 1.446-3(c)(4)(ii)).

(4) Failure to perform--(i) In general. The failure of an issuer to

perform its obligations under a debt instrument is not itself an

alteration of a legal right or obligation and is not a modification.

(ii) Holder's temporary forbearance. Notwithstanding paragraph

(c)(1) of this section, absent a written or oral agreement to alter

other terms of the debt instrument, an agreement by the holder to stay

collection or temporarily waive an acceleration clause or similar

default right (including such a waiver following the exercise of a

right to demand payment in full) is not a modification unless and until

the forbearance remains in effect for a period that exceeds--

(A) Two years following the issuer's initial failure to perform;

and

(B) Any additional period during which the parties conduct good

faith negotiations or during which the issuer is in a title 11 or

similar case (as defined in section 368(a)(3)(A)).

(5) Failure to exercise an option. If a party to a debt instrument

has an option to change a term of an instrument, the failure of the

party to exercise that option is not a modification.

(6) Time of modification--(i) In general. Except as provided in

this paragraph (c)(6), an agreement to change a term of a debt

instrument is a modification at the time the issuer and holder enter

into the agreement, even if the change in the term is not immediately

effective.

(ii) Closing conditions. If the parties condition a change in a

term of a debt instrument on reasonable closing conditions (for

example, shareholder, regulatory, or senior creditor approval, or

additional financing), a modification occurs on the closing date of the

agreement. Thus, if the reasonable closing conditions do not occur so

that the change in the term does not become effective, a modification

does not occur.

(iii) Bankruptcy proceedings. If a change in a term of a debt

instrument occurs pursuant to a plan of reorganization in a title 11 or

similar case (within the meaning of section 368(a)(3)(A)), a

modification occurs upon the effective date of the plan. Thus, unless

the plan becomes effective, a modification does not occur.

(d) Examples. The following examples illustrate the provisions of

paragraph (c) of this section:

Example 1. Reset bond. A bond provides for the interest rate to

be reset every 49 days through an auction by a remarketing agent.

The reset of the interest rate occurs by operation of the terms of

the bond and is not an alteration described in paragraph (c)(2) of

this section. Thus, the reset of the interest rate is not a

modification.

Example 2. Obligation to maintain collateral. The original terms

of a bond provide that the bond must be secured by a certain type of

collateral having a specified value. The terms also require the

issuer to substitute collateral if the value of the original

collateral decreases. Any substitution of collateral that is

required to maintain the value of the collateral occurs by operation

of the terms of the bond and is not an alteration described in

paragraph (c)(2) of this section. Thus, such a substitution of

collateral is not a modification.

Example 3. Alteration contingent on an act of a party. The

original terms of a bond provide that the interest rate is 9

percent. The terms also provide that, if the issuer files an

effective registration statement covering the bonds with the

Securities and Exchange Commission, the interest rate will decrease

to 8 percent. If the issuer registers the bond, the resulting

decrease in the interest rate occurs by operation of the terms of

the bond and is not an alteration described in paragraph (c)(2) of

this section. Thus, such a decrease in the interest rate is not a

modification.

Example 4. Substitution of a new obligor occurring by operation

of the terms of the debt instrument. Under the original terms of a

bond issued by a corporation, an acquirer of substantially all of

the corporation's assets may assume the corporation's obligations

under the bond. Substantially all of the corporation's assets are

acquired by another corporation and the acquiring corporation

becomes the new obligor on the bond. Under paragraph (c)(2)(i) of

this section, the substitution of a new obligor, even though it

occurs by operation of the terms of the bond, is a modification.

Example 5. Defeasance with release of covenants. (i) A

corporation issues a 30-year, recourse bond. Under the terms of the

bond, the corporation may secure a release of the financial and

restrictive covenants by placing in trust government securities as

collateral that will provide interest and principal payments

sufficient to satisfy all scheduled payments on the bond. The

corporation remains obligated for all payments, including the

contribution of additional securities to the trust if necessary to

provide sufficient amounts to satisfy the payment obligations. Under

paragraph (c)(3) of this section, the option to defease the bond is

a unilateral option.

(ii) The alterations occur by operation of the terms of the debt

instrument and are not described in paragraph (c)(2) of this

section.

[[Page 32932]]

Thus, such a release of the covenants is not a modification.

Example 6. Legal defeasance. Under the terms of a recourse bond,

the issuer may secure a release of the financial and restrictive

covenants by placing in trust government securities that will

provide interest and principal payments sufficient to satisfy all

scheduled payments on the bond. Upon the creation of the trust, the

issuer is released from any recourse liability on the bond and has

no obligation to contribute additional securities to the trust if

the trust funds are not sufficient to satisfy the scheduled payments

on the bond. The release of the issuer is an alteration described in

paragraph (c)(2)(i) of this section, and thus is a modification.

Example 7. Exercise of an option by a holder that reduces

amounts payable. (i) A financial institution holds a residential

mortgage. Under the original terms of the mortgage, the financial

institution has an option to decrease the interest rate. The

financial institution anticipates that, if market interest rates

decline, it may exercise this option in lieu of the mortgagor

refinancing with another lender.

(ii) The financial institution exercises the option to reduce

the interest rate. The exercise of the option results in a reduction

in scheduled payments and is an alteration described in paragraph

(c)(2)(iii) of this section. Thus, the change in interest rate is a

modification.

Example 8. Conversion of adjustable rate to fixed rate mortgage.

(i) The original terms of a mortgage provide for a variable interest

rate, reset annually based on the value of an objective index. Under

the terms of the mortgage, the mortgagor may, upon the payment of a

fee equal to a specified percentage of the outstanding principal

amount of the mortgage, convert to a fixed rate of interest as

determined based on the value of a second objective index. The

exercise of the option does not require the consent or approval of

any person or create a right of the holder to alter the terms of, or

to put, the instrument.

(ii) Because the required consideration to exercise the option

is a specified amount fixed on the issue date, the exercise of the

option is unilateral as defined in paragraph (c)(3) of this section.

The conversion to a fixed rate of interest is not an alteration

described in paragraph (c)(2) of this section. Thus, the change in

the type of interest rate occurs by operation of the terms of the

instrument and is not a modification.

Example 9. Holder's option to increase interest rate. (i) A

corporation issues an 8-year note to a bank in exchange for cash.

Under the terms of the note, the bank has the option to increase the

rate of interest by a specified amount upon a certain decline in the

corporation's credit rating. The bank's right to increase the

interest rate is a unilateral option as described in paragraph

(c)(3) of this section.

(ii) The credit rating of the corporation declines below the

specified level. The bank exercises its option to increase the rate

of interest. The increase in the rate of interest occurs by

operation of the terms of the note and does not result in a deferral

or a reduction in the scheduled payments or any other alteration

described in paragraph (c)(2) of this section. Thus, the change in

interest rate is not a modification.

Example 10. Issuer's right to defer payment of interest. A

corporation issues a 5-year note. Under the terms of the note,

interest is payable annually at the rate of 10 percent. The

corporation, however, has an option to defer any payment of interest

until maturity. For any payments that are deferred, interest will

compound at a rate of 12 percent. The exercise of the option, which

results in the deferral of payments, does not result from the

exercise of an option by the holder. The exercise of the option

occurs by operation of the terms of the debt instrument and is not a

modification.

Example 11. Holder's option to grant deferral of payment. (i) A

corporation issues a 10-year note to a bank in exchange for cash.

Interest on the note is payable semi-annually. Under the terms of

the note, the bank may grant the corporation the right to defer all

or part of the interest payments. For any payments that are

deferred, interest will compound at a rate 150 basis points greater

than the stated rate of interest.

(ii) The corporation encounters financial difficulty and is

unable to satisfy its obligations under the note. The bank exercises

its option under the note and grants the corporation the right to

defer payments. The exercise of the option results in a right of the

corporation to defer scheduled payments and, under paragraph

(c)(3)(i) of this section, is not a unilateral option. Thus, the

alteration is described in paragraph (c)(2)(iii) of this section and

is a modification.

Example 12. Alteration requiring consent. The original terms of

a bond include a provision that the issuer may extend the maturity

of the bond with the consent of the holder. Because any extension

pursuant to this term requires the consent of both parties, such an

extension does not occur by the exercise of a unilateral option (as

defined in paragraph (c)(3) of this section) and is a modification.

Example 13. Waiver of an acceleration clause. Under the terms of

a bond, if the issuer fails to make a scheduled payment, the full

principal amount of the bond is due and payable immediately.

Following the issuer's failure to make a scheduled payment, the

holder temporarily waives its right to receive the full principal

for a period ending one year from the date of the issuer's default

to allow the issuer to obtain additional financial resources. Under

paragraph (c)(4)(ii) of this section, the temporary waiver in this

situation is not a modification. The result would be the same if the

terms provided the holder with the right to demand the full

principal amount upon the failure of the issuer to make a scheduled

payment and, upon such a failure, the holder exercised that right

and then waived the right to receive the payment for one year.

(e) Significant modifications. Whether the modification of a debt

instrument is a significant modification is determined under the rules

of this paragraph (e). Paragraph (e)(1) of this section provides a

general rule for determining the significance of modifications not

otherwise addressed in this paragraph (e). Paragraphs (e) (2) through

(6) of this section provide specific rules for determining the

significance of certain types of modifications. Paragraph (f) of this

section provides rules of application, including rules for

modifications that are effective on a deferred basis or upon the

occurrence of a contingency.

(1) General rule. Except as otherwise provided in paragraphs (e)(2)

through (e)(6) of this section, a modification is a significant

modification only if, based on all facts and circumstances, the legal

rights or obligations that are altered and the degree to which they are

altered are economically significant. In making a determination under

this paragraph (e)(1), all modifications to the debt instrument (other

than modifications subject to paragraphs (e) (2) through (6) of this

section) are considered collectively, so that a series of such

modifications may be significant when considered together although each

modification, if considered alone, would not be significant.

(2) Change in yield--(i) Scope of rule. This paragraph (e)(2)

applies to debt instruments that provide for only fixed payments, debt

instruments with alternative payment schedules subject to Sec. 1.1272-

1(c), debt instruments that provide for a fixed yield subject to

Sec. 1.1272-1(d) (such as certain demand loans), and variable rate debt

instruments. Whether a change in the yield of other debt instruments

(for example, a contingent payment debt instrument) is a significant

modification is determined under paragraph (e)(1) of this section.

(ii) In general. A change in the yield of a debt instrument is a

significant modification if the yield computed under paragraph

(e)(2)(iii) of this section varies from the annual yield on the

unmodified instrument (determined as of the date of the modification)

by more than the greater of--

(A) \1/4\ of one percent (25 basis points); or

(B) 5 percent of the annual yield of the unmodified instrument (.05

x annual yield).

(iii) Yield of the modified instrument--(A) In general. The yield

computed under this paragraph (e)(2)(iii) is the annual yield of a debt

instrument with--

(1) an issue price equal to the adjusted issue price of the

unmodified instrument on the date of the modification (increased by any

accrued but unpaid interest and decreased by any accrued bond issuance

premium not

[[Page 32933]]

yet taken into account, and increased or decreased, respectively, to

reflect payments made to the issuer or to the holder as consideration

for the modification); and

(2) payments equal to the payments on the modified debt instrument

from the date of the modification.

(B) Prepayment penalty. For purposes of this paragraph (e)(2)(iii),

a commercially reasonable prepayment penalty for a pro rata prepayment

(as defined in Sec. 1.1275-2(f)) is not consideration for a

modification of a debt instrument and is not taken into account in

determining the yield of the modified instrument.

(iv) Variable rate debt instruments. For purposes of this paragraph

(e)(2), the annual yield of a variable rate debt instrument is the

annual yield of the equivalent fixed rate debt instrument (as defined

in Sec. 1.1275-5(e)) which is constructed based on the terms of the

instrument (either modified or unmodified, whichever is applicable) as

of the date of the modification.

(3) Changes in timing of payments--(i) In general. A modification

that changes the timing of payments (including any resulting change in

the amount of payments) due under a debt instrument is a significant

modification if it results in the material deferral of scheduled

payments. The deferral may occur either through an extension of the

final maturity date of an instrument or through a deferral of payments

due prior to maturity. The materiality of the deferral depends on all

the facts and circumstances, including the length of the deferral, the

original term of the instrument, the amounts of the payments that are

deferred, and the time period between the modification and the actual

deferral of payments.

(ii) Safe-harbor period. The deferral of one or more scheduled

payments within the safe-harbor period is not a material deferral if

the deferred payments are unconditionally payable no later than at the

end of the safe-harbor period. The safe-harbor period begins on the

original due date of the first scheduled payment that is deferred and

extends for a period equal to the lesser of five years or 50 percent of

the original term of the instrument. For purposes of this paragraph

(e)(3)(ii), the term of an instrument is determined without regard to

any option to extend the original maturity and deferrals of de minimis

payments are ignored. If the period during which payments are deferred

is less than the full safe-harbor period, the unused portion of the

period remains a safe-harbor period for any subsequent deferral of

payments on the instrument.

(4) Change in obligor or security--(i) Substitution of a new

obligor on recourse debt instruments--(A) In general. Except as

provided in paragraph (e)(4)(i) (B), (C), or (D) of this section, the

substitution of a new obligor on a recourse debt instrument is a

significant modification.

(B) Section 381(a) transaction. The substitution of a new obligor

is not a significant modification if the acquiring corporation (within

the meaning of section 381) becomes the new obligor pursuant to a

transaction to which section 381(a) applies, the transaction does not

result in a change in payment expectations, and the transaction (other

than a reorganization within the meaning of section 368(a)(1)(F)) does

not result in a significant alteration.

(C) Certain asset acquisitions. The substitution of a new obligor

is not a significant modification if the new obligor acquires

substantially all of the assets of the original obligor, the

transaction does not result in a change in payment expectations, and

the transaction does not result in a significant alteration.

(D) Tax-exempt bonds. The substitution of a new obligor on a tax-

exempt bond is not a significant modification if the new obligor is a

related entity to the original obligor as defined in section

168(h)(4)(A) and the collateral securing the instrument continues to

include the original collateral.

(E) Significant alteration. For purposes of this paragraph (e)(4),

a significant alteration is an alteration that would be a significant

modification but for the fact that the alteration occurs by operation

of the terms of the instrument.

(F) Section 338 election. For purposes of this section, an election

under section 338 following a qualified stock purchase of an issuer's

stock does not result in the substitution of a new obligor.

(G) Bankruptcy proceedings. For purposes of this section, the

filing of a petition in a title 11 or similar case (as defined in

section 368(a)(3)(A)) by itself does not result in the substitution of

a new obligor.

(ii) Substitution of a new obligor on nonrecourse debt instruments.

The substitution of a new obligor on a nonrecourse debt instrument is

not a significant modification.

(iii) Addition or deletion of co-obligor. The addition or deletion

of a co-obligor on a debt instrument is a significant modification if

the addition or deletion of the co-obligor results in a change in

payment expectations. If the addition or deletion of a co-obligor is

part of a transaction or series of related transactions that results in

the substitution of a new obligor, however, the transaction is treated

as a substitution of a new obligor (and is tested under paragraph

(e)(4)(i)) of this section rather than as an addition or deletion of a

co-obligor.

(iv) Change in security or credit enhancement--(A) Recourse debt

instruments. A modification that releases, substitutes, adds or

otherwise alters the collateral for, a guarantee on, or other form of

credit enhancement for a recourse debt instrument is a significant

modification if the modification results in a change in payment

expectations.

(B) Nonrecourse debt instruments. A modification that releases,

substitutes, adds or otherwise alters a substantial amount of the

collateral for, a guarantee on, or other form of credit enhancement for

a nonrecourse debt instrument is a significant modification. A

substitution of collateral is not a significant modification, however,

if the collateral is fungible or otherwise of a type where the

particular units pledged are unimportant (for example, government

securities or financial instruments of a particular type and rating).

In addition, the substitution of a similar commercially available

credit enhancement contract is not a significant modification, and an

improvement to the property securing a nonrecourse debt instrument does

not result in a significant modification.

(v) Change in priority of debt. A change in the priority of a debt

instrument relative to other debt of the issuer is a significant

modification if it results in a change in payment expectations.

(vi) Change in payment expectations--(A) In general. For purposes

of this section, a change in payment expectations occurs if, as a

result of a transaction--

(1) There is a substantial enhancement of the obligor's capacity to

meet the payment obligations under a debt instrument and that capacity

was primarily speculative prior to the modification and is adequate

after the modification; or

(2) There is a substantial impairment of the obligor's capacity to

meet the payment obligations under a debt instrument and that capacity

was adequate prior to the modification and is primarily speculative

after the modification.

(B) Obligor's capacity. The obligor's capacity includes any source

for payment, including collateral, guarantees, or other credit

enhancement.

(5) Changes in the nature of a debt instrument--(i) Property that

is not

[[Page 32934]]

debt. A modification of a debt instrument that results in an instrument

or property right that is not debt for federal income tax purposes is a

significant modification. For purposes of this paragraph (e)(5)(i), any

deterioration in the financial condition of the obligor between the

issue date of the unmodified instrument and the date of modification

(as it relates to the obligor's ability to repay the debt) is not taken

into account unless, in connection with the modification, there is a

substitution of a new obligor or the addition or deletion of a co-

obligor.

(ii) Change in recourse nature--(A) In general. Except as provided

in paragraph (e)(5)(ii)(B) of this section, a change in the nature of a

debt instrument from recourse (or substantially all recourse) to

nonrecourse (or substantially all nonrecourse) is a significant

modification. Thus, for example, a legal defeasance of a debt

instrument in which the issuer is released from all liability to make

payments on the debt instrument (including an obligation to contribute

additional securities to a trust if necessary to provide sufficient

funds to meet all scheduled payments on the instrument) is a

significant modification. Similarly, a change in the nature of the debt

instrument from nonrecourse (or substantially all nonrecourse) to

recourse (or substantially all recourse) is a significant modification.

If an instrument is not substantially all recourse or not substantially

all nonrecourse either before or after a modification, the significance

of the modification is determined under paragraph (e)(1) of this

section.

(B) Exceptions--(1) Defeasance of tax-exempt bonds. A defeasance of

a tax-exempt bond is not a significant modification even if the issuer

is released from any liability to make payments under the instrument if

the defeasance occurs by operation of the terms of the original bond

and the issuer places in trust government securities or tax-exempt

government bonds that are reasonably expected to provide interest and

principal payments sufficient to satisfy the payment obligations under

the bond.

(2) Original collateral. A modification that changes a recourse

debt instrument to a nonrecourse debt instrument is not a significant

modification if the instrument continues to be secured only by the

original collateral and the modification does not result in a change in

payment expectations. For this purpose, if the original collateral is

fungible or otherwise of a type where the particular units pledged are

unimportant (for example, government securities or financial

instruments of a particular type and rating), replacement of some or

all units of the original collateral with other units of the same or

similar type and aggregate value is not considered a change in the

original collateral.

(6) Accounting or financial covenants. A modification that adds,

deletes, or alters customary accounting or financial covenants is not a

significant modification.

(f) Rules of application--(1) Testing for significance--(i) In

general. Whether a modification of any term is a significant

modification is determined under each applicable rule in paragraphs

(e)(2) through (6) of this section and, if not specifically addressed

in those rules, under the general rule in paragraph (e)(1) of this

section. For example, a deferral of payments that changes the yield of

a fixed rate debt instrument must be tested under both paragraphs

(e)(2) and (3) of this section.

(ii) Contingent modifications. If a modification described in

paragraphs (e)(2) through (5) of this section is effective only upon

the occurrence of a substantial contingency, whether or not the change

is a significant modification is determined under paragraph (e)(1) of

this section rather than under paragraphs (e)(2) through (5) of this

section.

(iii) Deferred modifications. If a modification described in

paragraphs (e) (4) and (5) of this section is effective on a

substantially deferred basis, whether or not the change is a

significant modification is determined under paragraph (e)(1) of this

section rather than under paragraphs (e) (4) and (5) of this section.

(2) Modifications that are not significant. If a rule in paragraphs

(e) (2) through (4) of this section prescribes a degree of change in a

term of a debt instrument that is a significant modification, a change

of the same type but of a lesser degree is not a significant

modification under that rule. For example, a 20 basis point change in

the yield of a fixed rate debt instrument is not a significant

modification under paragraph (e)(2) of this section. Likewise, if a

rule in paragraph (e)(4) of this section requires a change in payment

expectations for a modification to be significant, a modification of

the same type that does not result in a change in payment expectations

is not a significant modification under that rule.

(3) Cumulative effect of modifications. Two or more modifications

of a debt instrument over any period of time constitute a significant

modification if, had they been done as a single change, the change

would have resulted in a significant modification under paragraph (e)

of this section. Thus, for example, a series of changes in the maturity

of a debt instrument constitutes a significant modification if,

combined as a single change, the change would have resulted in a

significant modification. The significant modification occurs at the

time that the cumulative modification would be significant under

paragraph (e) of this section. In testing for a change of yield under

paragraph (e)(2) of this section, however, any prior modification

occurring more than 5 years before the date of the modification being

tested is disregarded.

(4) Modifications of different terms. Modifications of different

terms of a debt instrument, none of which separately would be a

significant modification under paragraphs (e)(2) through (6) of this

section, do not collectively constitute a significant modification. For

example, a change in yield that is not a significant modification under

paragraph (e)(2) of this section and a substitution of collateral that

is not a significant modification under paragraph (e)(4)(iv) of this

section do not together result in a significant modification. Although

the significance of each modification is determined independently, in

testing a particular modification it is assumed that all other

simultaneous modifications have already occurred.

(5) Definitions. For purposes of this section:

(i) Issuer and obligor are used interchangeably and mean the issuer

of a debt instrument or a successor obligor.

(ii) Variable rate debt instrument and contingent payment debt

instrument have the meanings given those terms in section 1275 and the

regulations thereunder.

(iii) Tax-exempt bond means a state or local bond that satisfies

the requirements of section 103(a).

(iv) Conduit loan and conduit borrower have the same meanings as in

Sec. 1.150-1(b).

(6) Certain rules for tax-exempt bonds--(i) Conduit loans. For

purposes of this section, the obligor of a tax-exempt bond is the

entity that actually issues the bond and not a conduit borrower of bond

proceeds. In determining whether there is a significant modification of

a tax-exempt bond, however, transactions between holders of the tax-

exempt bond and a borrower of a conduit loan may be an indirect

modification under paragraph (a)(1) of this section. For example, a

[[Page 32935]]

payment by the holder of a tax-exempt bond to a conduit borrower to

waive a call right may result in an indirect modification of the tax-

exempt bond by changing the yield on that bond.

(ii) Recourse nature--(A) In general. For purposes of this section,

a tax-exempt bond that does not finance a conduit loan is a recourse

debt instrument.

(B) Proceeds used for conduit loans. For purposes of this section,

a tax-exempt bond that finances a conduit loan is a recourse debt

instrument unless both the bond and the conduit loan are nonrecourse

instruments.

(C) Government securities as collateral. Notwithstanding paragraphs

(f)(6)(ii) (A) and (B) of this section, for purposes of this section a

tax-exempt bond that is secured only by a trust holding government

securities or tax-exempt government bonds that are reasonably expected

to provide interest and principal payments sufficient to satisfy the

payment obligations under the bond is a nonrecourse instrument.

(g) Examples. The following examples illustrate the provisions of

paragraphs (e) and (f) of this section:

Example 1. Modification of call right. (i) Under the terms of a

30-year, fixed-rate bond, the issuer can call the bond for 102

percent of par at the end of ten years or for 101 percent of par at

the end of 20 years. At the end of the eighth year, the holder of

the bond pays the issuer to waive the issuer's right to call the

bond at the end of the tenth year. On the date of the modification,

the issuer's credit rating is approximately the same as when the

bond was issued, but market rates of interest have declined from

that date.

(ii) The holder's payment to the issuer changes the yield on the

bond. Whether the change in yield is a significant modification

depends on whether the yield on the modified bond varies from the

yield on the original bond by more than the change in yield as

described in paragraph (e)(2)(ii) of this section.

(iii) If the change in yield is not a significant modification,

the elimination of the issuer's call right must also be tested for

significance. Because the specific rules of paragraphs (e)(2)

through (e)(6) of this section do not address this modification, the

significance of the modification must be determined under the

general rule of paragraph (e)(1) of this section.

Example 2. Extension of maturity and change in yield. (i) A

zero-coupon bond has an original maturity of ten years. At the end

of the fifth year, the parties agree to extend the maturity for a

period of two years without increasing the stated redemption price

at maturity (i.e., there are no additional payments due between the

original and extended maturity dates, and the amount due at the

extended maturity date is equal to the amount due at the original

maturity date).

(ii) The deferral of the scheduled payment at maturity is tested

under paragraph (e)(3) of this section. The safe-harbor period under

paragraph (e)(3)(ii) of this section starts with the date the

payment that is being deferred is due. For this modification, the

safe-harbor period starts on the original maturity date, and ends

five years from this date. All payments deferred within this period

are unconditionally payable before the end of the safe-harbor

period. Thus, the deferral of the payment at maturity for a period

of two years is not a material deferral under the safe-harbor rule

of paragraph (e)(3)(ii) of this section and thus is not a

significant modification.

(iii) Even though the extension of maturity is not a significant

modification under paragraph (e)(3)(ii) of this section, the

modification also decreases the yield of the bond. The change in

yield must be tested under paragraph (e)(2) of this section.

Example 3. Change in yield resulting from reduction of

principal. (i) A debt instrument issued at par has an original

maturity of ten years and provides for the payment of $100,000 at

maturity with interest payments at the rate of 10 percent payable at

the end of each year. At the end of the fifth year, and after the

annual payment of interest, the issuer and holder agree to reduce

the amount payable at maturity to $80,000. The annual interest rate

remains at 10 percent but is payable on the reduced principal.

(ii) In applying the change in yield rule of paragraph (e)(2) of

this section, the yield of the instrument after the modification

(measured from the date that the parties agree to the modification

to its final maturity date) is computed using the adjusted issue

price of $100,000. With four annual payments of $8,000, and a

payment of $88,000 at maturity, the yield on the instrument after

the modification for purposes of determining if there has been a

significant modification under paragraph (e)(2)(i) of this section

is 4.332 percent. Thus, the reduction in principal is a significant

modification.

Example 4. Deferral of scheduled interest payments. (i) A 20-

year debt instrument issued at par provides for the payment of

$100,000 at maturity with annual interest payments at the rate of 10

percent. At the beginning of the eleventh year, the issuer and

holder agree to defer all remaining interest payments until maturity

with compounding. The yield of the modified instrument remains at 10

percent.

(ii) The safe-harbor period of paragraph (e)(3)(ii) of this

section begins at the end of the eleventh year, when the interest

payment for that year is deferred, and ends at the end of the

sixteenth year. However, the payments deferred during this period

are not unconditionally payable by the end of that 5-year period.

Thus, the deferral of the interest payments is not within the safe-

harbor period.

(iii) This modification materially defers the payments due under

the instrument and is a significant modification under paragraph

(e)(3)(i) of this section.

Example 5. Assumption of mortgage with increase in interest

rate. (i) A recourse debt instrument with a 9 percent annual yield

is secured by an office building. Under the terms of the instrument,

a purchaser of the building may assume the debt and be substituted

for the original obligor if the purchaser has a specified credit

rating and if the interest rate on the instrument is increased by

one-half percent (50 basis points). The building is sold, the

purchaser assumes the debt, and the interest rate increases by 50

basis points.

(ii) If the purchaser's acquisition of the building does not

satisfy the requirements of paragraphs (e)(4)(i) (B) or (C) of this

section, the substitution of the purchaser as the obligor is a

significant modification under paragraph (e)(4)(i)(A) of this

section.

(iii) If the purchaser acquires substantially all of the assets

of the original obligor, the assumption of the debt instrument will

not result in a significant modification if there is not a change in

payment expectations and the assumption does not result in a

significant alteration.

(iv) The change in the interest rate, if tested under the rules

of paragraph (e)(2) of this section, would result in a significant

modification. The change in interest rate that results from the

transaction is a significant alteration. Thus, the transaction does

not meet the requirements of paragraph (e)(4)(i)(E) of this section

and is a significant modification under paragraph (e)(4)(i)(A) of

this section.

Example 6. Assumption of mortgage. (i) A recourse debt

instrument is secured by a building. In connection with the sale of

the building, the purchaser of the building assumes the debt and is

substituted as the new obligor on the debt instrument. The purchaser

does not acquire substantially all of the assets of the original

obligor.

(ii) The transaction does not satisfy any of the exceptions set

forth in paragraph (e)(4)(i) (B) or (C) of this section. Thus, the

substitution of the purchaser as the obligor is a significant

modification under paragraph (e)(4)(i)(A) of this section.

(iii) Section 1274(c)(4), however, provides that if a debt

instrument is assumed in connection with the sale or exchange of

property, the assumption is not taken into account in determining if

section 1274 applies to the debt instrument unless the terms and

conditions of the debt instrument are modified in connection with

the sale or exchange. Because the purchaser assumed the debt

instrument in connection with the sale of property and the debt

instrument was not otherwise modified, the debt instrument is not

retested to determine whether it provides for adequate stated

interest.

Example 7. Substitution of a new obligor in section 381(a)

transaction. (i) The interest rate on a 30-year debt instrument

issued by a corporation provides for a variable rate of interest

that is reset annually on June 1st based on an objective index.

(ii) In the tenth year, the issuer merges (in a transaction to

which section 381(a) applies) into another corporation that becomes

the new obligor on the debt instrument. The merger occurs on June

1st, at which time the interest rate is also reset by operation of

the terms of the instrument. The new interest rate varies from the

previous interest rate by more than the greater of 25 basis points

and 5 percent of the annual yield of the unmodified instrument. The

substitution of a new obligor does not result in a change in payment

expectations.

[[Page 32936]]

(iii) The substitution of the new obligor occurs in a section

381(a) transaction and does not result in a change in payment

expectations. Although the interest rate changed by more than the

greater of 25 basis points and 5 percent of the annual yield of the

unmodified instrument, this alteration did not occur as a result of

the transaction and is not a significant alteration under paragraph

(e)(4)(i)(E) of this section. Thus, the substitution meets the

requirements of paragraph (e)(4)(i)(B) of this section and is not a

significant modification.

Example 8. Substitution of credit enhancement contract. (i)

Under the terms of a recourse debt instrument, the issuer's

obligations are secured by a letter of credit from a specified bank.

The debt instrument does not contain any provision allowing a

substitution of a letter of credit from a different bank. The

specified bank, however, encounters financial difficulty and rating

agencies lower its credit rating. The issuer and holder agree that

the issuer will substitute a letter of credit from another bank with

a higher credit rating.

(ii) Under paragraph (e)(4)(iv)(A) of this section, the

substitution of a different credit enhancement contract is not a

significant modification of a recourse debt instrument unless the

substitution results in a change in payment expectations. While the

substitution of a new letter of credit by a bank with a higher

credit rating does not itself result in a change in payment

expectations, such a substitution may result in a change in payment

expectations under certain circumstances (for example, if the

obligor's capacity to meet payment obligations is dependent on the

letter of credit and the substitution substantially enhances that

capacity from primarily speculative to adequate).

Example 9. Improvement to collateral securing nonrecourse debt.

A parcel of land and its improvements, a shopping center, secure a

nonrecourse debt instrument. The obligor expands the shopping center

with the construction of an additional building on the same parcel

of land. After the construction, the improvements that secure the

nonrecourse debt include the new building. The building is an

improvement to the property securing the nonrecourse debt instrument

and its inclusion in the collateral securing the debt is not a

significant modification under paragraph (e)(4)(iv)(B) of this

section.

(h) Effective date. This section applies to alterations of the

terms of a debt instrument on or after September 24, 1996. Taxpayers,

however, may rely on this section for alterations of the terms of a

debt instrument after December 2, 1992, and before September 24, 1996.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: May 31, 1996.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 96-15830 Filed 6-25-96; 8:45 am]

BILLING CODE 4830-01-U