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On Friday, the Treasury Department issued final regulations under Code section 1001 relating to the modification of debt instruments. In relevant part, the regulation provides that, following the modification of a debt instrument, the classification of the modified instrument as debt or equity for federal income tax purposes does not take into account any deterioration in the financial condition of the obligor. Treas. Reg. § 1.1001-3(f)(7)(ii)(A).
The only public comment on the proposed regulations noted that the existing regulation does not contain rules for determining ...
Times are tough, and many troubled companies are facing the need to modify debts that were issued when times were better (and the companies were financially much stronger). For companies that wish to modify their debts, and for investors that hold those debts, federal tax law imposes an unfortunate limitation. An outstanding debt that undergoes a “significant modification” is treated as having been exchanged for a new instrument with the modified terms. See Treas. Reg. § 1.1001-3. As a result, holders of the debt will generally be required to recognize gain or loss on the deemed exchange of the debt and, in some instances, the issuer may be forced to recognize income as well. Thus, the question of whether a modification will result in a deemed exchange of the debt for federal income tax purposes has the potential to complicate, or even derail, potentially beneficial debt modifications.