2020年6月05日

Modification of Intra-Group Debt Instruments

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Background. Just as with debt instruments between unrelated parties, the current economic downturn may cause related parties to want to modify the terms of debt instruments existing between them. And as with debt instruments between unrelated parties, modification of debt instruments between related parties may have a number of tax consequences. Certain “significant modifications” of a debt instrument will result in a deemed exchange of the unmodified instrument (“old debt”) for the modified debt instrument (“new debt”). The old debt will be treated as redeemed for an amount equal to the “issue price” of the new debt. The new debt will be treated as a newly issued debt instrument with a new issue price. If the debt instrument is not publicly traded, then the issue price of the new debt instrument is generally equal to the principal amount, provided that the debt instrument bears stated interest at least equal to the “Applicable Federal Rate.” What constitutes a “modification” and the determination of when a modification is “significant” are the subjects of this Legal Update.

Tax consequences to holder. The holder of a debt instrument may recognize gain or loss due to the modification. The holder will generally have gain or loss equal to the difference between the issue price of the new debt and the holder’s basis in the old debt, which will usually be a capital gain or loss. Further, if the issue price of the new debt is less than the “stated redemption price at maturity” (“SRPM”) by more than a de minimis amount, the new debt will have “original issue discount” (“OID”), which will generally be includible as income by the holder over the term of the new debt. In this case, an initial holder will generally have a capital loss and will have OID inclusions over the term of the new debt that are ordinary. (A typical debt instrument held from issuance would have no gain or de minimis gain and would not typically be issued with OID.) Conversely, if the issue price of the new debt is greater than the stated redemption price of the new debt, the premium will be deductible over the term of the instrument, if the holder elects.

Tax consequences to issuer. The issuer may recognize cancellation of indebtedness (“COD”) income due to the modification.  A deficit in the issue price of the new debt over the adjusted issue price of the old debt results in COD income. An excess of the issue price of the new debt over the adjusted issue price of the old debt results in deductible premium (which may not be immediately deductible).  Further, the new debt may be treated as issued with OID. If the issue price of the new debt is less than its SRPM by more than a de minimis amount, the new debt will have OID, which will generally be deductible by the issuer. Accordingly, the issuer may have an immediate COD income inclusion that will be offset by OID deductions but only over the term of the new debt. If the issue price of the new debt is greater than the SRPM of the new debt, the premium will reduce interest deductions.  

Significant modifications in general. Treas. Reg. 1.1001-1(a) provides that a deemed exchange will occur if a debt instrument is modified so that it differs “materially either in kind or in extent” from the original debt instrument. There is a two-step analysis to determine whether an altered debt instrument differs materially either in kind or in extent from the original debt instrument. First, is the alteration a “modification?” And second, is any modification “significant?”

Definition of “modification.” A modification generally means any change or alteration to a right or obligation of the issuer or holder. The change can be evidenced in writing or by oral agreement. The conduct of the parties is sufficient evidence to suggest that a change or alteration has occurred. The form of the modification is generally irrelevant and could occur, for example, through an actual debt exchange by the issuer or an amendment to a loan agreement. Generally, a modification is treated as occurring at the time the issuer and holder enter into an agreement (even if the alteration is not immediately effective), unless the parties condition the alteration on reasonable closing conditions, in which case the modification occurs on the closing date. A change due to the operation of the terms of the debt instrument (for example, variable interest rates) is generally not considered a modification.

Forbearance. Modification is broadly construed, but the failure of an issuer to perform its obligations under a debt instrument is not a modification. The holder may agree to stay collection or temporarily waive an acceleration clause or similar default right. This is not a modification until the forbearance remains in effect for a period that exceeds two years following the issuer’s failure to perform and any additional period during which the parties conduct good faith negotiations. If the parties agree to new terms, it is clear that there will be a modification.

Definition of “significant.” A modification will be “significant” if it falls within one of several enumerated categories or, if not addressed in a category, is “economically significant.” The enumerated categories are found in Treas. Reg. 1.1001-3. They give the parties some leeway to modify a debt instrument without tax consequences. The enumerated categories include these: certain changes in yield; certain changes in timing of payments; certain changes in obligor or security; change in nature of debt instrument; and certain changes in accounting or financial covenants. Modifications that fall under different enumerated rules are not cumulative. Thus, for example, a change in yield and a substitution of collateral would be analyzed separately. Two or more modifications falling under a single specific enumerated rule constitute a significant modification if, effected as a single change, that change would be considered significant. If a modification is effective only upon a contingency, its significance is tested under the catch-all economically significant rule. If a modification that is a change in obligor or security or change in nature of instrument is effective on a substantially deferred basis, its significance is tested under the economically significant rule.

Change in yield. A modification that changes the yield of a debt instrument will be significant if the modified yield varies by the greater of 1/4 of 1% or 5% of the annual yield of the unmodified instrument. Modified yield is the annual yield of the debt instrument with an issue price equal to the adjusted issue price of the unmodified instrument and payments equal to payments on the modified debt instrument from the date of modification. A commercially reasonable prepayment penalty for a pro rata prepayment is not considered a modification for this purpose.

Change to payment schedule. Any change to the payment schedule agreed to by the parties is a modification that would require testing for significance. A change in timing is significant if it results in the material deferral of scheduled payments. The materiality of the deferral depends upon all the facts and circumstances, including the length of 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. Under a safe harbor, the deferral of scheduled payments is not a material deferral if the deferred payments are unconditionally payable no later than at the end of the period that 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% of the original term of the instrument. 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.

Change in security. In the case of recourse debt, a modification that releases, substitutes, adds or otherwise alters the collateral for, or guarantee or other credit enhancement on, the instrument is a significant modification only if it results in a “change in payment expectations.”

In the case of nonrecourse debt, a modification that releases, substitutes, adds or otherwise alters a “substantial amount” of collateral for, a guarantee on or other credit enhancement for, the debt instrument is a significant modification. The rule does not mention change in payment expectations. Exceptions from the nonrecourse rule (modifications that are not significant modifications) include these: a substitution of collateral if the collateral is fungible or otherwise of a type where the particular units pledged are unimportant (for example, government securities); the substitution of a similar commercially available credit enhancement contract (for example, one bank letter of credit for another); and improvement to the property securing the debt.

Change in covenants. A modification that adds, deletes or alters customary accounting or financial covenants is not a significant modification. Financial covenants not constituting a significant modification include debt-to-cash-flow ratios, requirements on board meetings and employee compensation limitations.

General rule. If a modification is not addressed by a specific enumerated rule, it is tested under the general rule. The general rule states that “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 applying the economically significant test, all modifications subject to the test are considered collectively. 

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