Cottage Savings regulations finalized in conjunction with newly issued bad debt regulations.

The IRS recently finalized Regs. Sec. 1.1001-3. These regulations, originally proposed Dec. 2, 1992, are often referred to as the Cottage Savings regulations because they implement the Supreme Court's 1991 holding in Cottage Savings Association,, 111 Sup. Ct. 1503.

Personnel involved with debt modifications must understand these final regulations, which were effective Sept. 24, 1996. As illustrated, the modification of debt instruments may, in some cases, result in the recognition of gains or losses. In addition, the significant modification of a debt instrument may result in having to perform complicated original issue discount (OID) computations for the modified debt instrument (MDI).

Although Regs. Sec. 1.1001-3 is effective for the alteration of terms of a debt instrument on or after Sept. 24, 1996, taxpayers may choose to rely on it for alterations that occur after Dec. 2, 1992.

This article summarizes both Regs. Sec. 1.1001-3 and the elated new temporary bad debt regulations, Temp. Regs. Sec. 1.166-3T, and illustrates the potential pitfalls and benefits that exist for banks using a reserve method of accounting for bad debts.

Debt instruments are often altered in the ordinary course of business for a variety of reasons (e.g., debt restructuring, loan workouts necessitated by changing business conditions, etc.). To avoid unanticipated results, it is important to understand the potential tax consequences of modifying a debt instrument.

Regs. Sec. 1.1001-3 provides rules to determine whether an alteration in the terms of a debt instrument will result in the deemed exchange of the debt instrument for tax purposes. There are thee steps in doing so:

1. Determine whether the alteration of a debt instrument is a "modification."

2. If so, determine whether the modification is a "significant modification."

3. If the modification is "significant," a deemed exchange of the debt instrument has occurred and a gain or loss must be recognized at that time.

When Is an Alteration a Debt Modification?

An alteration of any legal right or obligation is considered to be a debt modification (Regs. Sec. 1.1001-3(c)). The modification can be made directly between the holder and the issuer or indirectly through third parties.

Alterations by operation of original terms of the agreement generally are not considered modifications. Regs. Sec. 1.1001-3(c)(1)(u) contains a number of exceptions to this rule. The following alterations, which occur by operation of the original debt instrument terms, are modifications (Regs. Sec. 1.1001-3(c)(2)):

* Any alteration that results in the substitution of a new obligor, the addition or deletion of a co-obligor or a change in the recourse nature of the debt instrument.

* Alterations that result from the exercise of unilateral options.

* Alterations that result from the exercise of holder options that defer or educe any scheduled payment of interest or principal.

* Generally, alterations that result in an instrument or property right that is not debt for Federal income tax purposes. The conversion of a debt instrument into stock of the issuer, however, is not a modification, if it is done according to conversion rights contained in the original agreement.

Nonperformance by an issuer does not necessarily result in a modification (Regs. Sec. 1.1001-3(c)(4)). A waiver of an acceleration clause or similar default right is not a modification for two years following the issuer's nonperformance. A longer period is allowed if the parties continue to conduct good faith negotiations or if there are pending bankruptcy proceedings.

Testing for Significant Debt Modifications

Regs. Sec. 1.1001-3(e) establishes four specific types of significant debt modifications and adds a general rule for modifications not covered by the four specific categories.

1. Change in yield.

2. Changes in timing of payments.

3. Change in obligor or security.

4. Changes in the nature of the debt instrument.

A modification is generally tested when the parties agree to a change, even if it is not effective immediately. The final regulations contain exceptions for changes subject to reasonable closing conditions or that occur as a result o f bankruptcy proceedings.

The modification of a debt instrument must be tested under each of the four categories to determine whether it is significant. If there are multiple modifications, the tests are applied as if all of the other modifications have already been performed. If the modifications are spread out over time, the modifications must be tested as if they were all performed at the same time.

Change in yield: A modification that changes the annual yield of a fixed-rate or variable-rate debt instrument generally is a significant modification if it varies from the annual yield on the unmodified instrument by the greater of 1/4 of one percentage point (25 basis points) or 5% of the instrument's original yield. The modified yield is measured from the date the parties agree to the modification to the debt instrument's final maturity date.

Changes in timing of payments: A change in the timing of payments is a significant modification if the payments due under a debt instrument are materially deferred. The deferral of one or more scheduled payments is not a material deferral if the deferred payments are unconditionally due no later than the end of the safe-harbor period.

The safe-harbor period begins on the date of the first deferred scheduled payment and continues for the lesser of five years or 50% of the debt instrument's original term. The unused portion of the safe-harbor period remains for any subsequent deferral of payments on the debt instrument.

Change in obligor or security: The substitution of a new obligor on a recourse note generally is considered to be a significant modification, with some exceptions. The following breakdowns can help determine when a change is considered significant and when it is not:

Significant modifications:

* The addition or material alteration of a guarantee or other credit enhancement on a nonrecourse instrument.

* The substitution or release of a substantial portion of collateral securing nonrecourse debt.

Not significant modifications:

* Substituting a new obligor as the result of certain tax-free corporate acquisitions is an exception, as long as the transaction does not result in a change in payment expectations or is not considered to be a significant alteration. (A significant alteration is an alteration that would be a significant modification except that it occurs by operation of the terms of the debt instrument.)

* Substituting a new obligor on a nonrecourse note.

* If the collateral on a recourse instrument is fungible, a substitution of collateral is not considered a significant modification unless the modification results in a change in payment assumptions. (A change in payment assumptions occurs if, as a result of the transaction, the obligor's capacity to meet the payment obligations goes from primarily speculative before the modification to adequate after the modification or from adequate before the modification to primarily speculative after the modification.)

* A modification on a recourse instrument that adds or materially alters a guarantee or other credit enhancement or the substitution or release of a substantial portion of collateral securing recourse debt, unless the modification results in a change in payment assumptions.

Changes in the nature of the debt instrument: A modification that changes the nature of a debt instrument generally is a significant modification if it changes in the following ways:

* A recourse debt instrument into a nonrecourse debt instrument;

* A nonrecourse debt instrument into a recourse debt instrument; or

* A debt instrument into an instrument or property that is not debt for Federal income tax purposes.

General rule: Regs. Sec. 1.1001-3(e) adds a new general rule for modifications not covered by the four specific rules. The general rule also applies to modifications for which specific rules are provided if the modification is effective on the occurrence of a substantial contingency.

A modification is significant if, based on all of the facts and circumstances, there has been an economically significant change in the legal rights or obligations of the debt instrument.

Consequences of Deemed Exchange Treatment

If a debt is significantly modified, the debt instrument held before the modification is deemed exchanged for the modified debt instrument (MDI). The amount realized on the exchange is based on the MDI's issue price computed under the original issue discount (OID) rules.

The MDI's issue price generally is equal to the obligation's face amount. But if the MDI calls for the payment of interest at a rate less than the applicable Federal rate (AFR), the issue price is equal to the present value of all required payments using the AFR.

A gain resulting from the significant modification of a debt instrument must be recognized if the MDI's issue price is higher than the tax basis of the unmodified debt instrument. This situation may arise if the debt instrument was purchased at a discount, issued with original discount or written down to reflect partial worthlessness.

To avoid the recognition of unexpected gains, review the resulting tax consequences before altering the terms of a debt instrument.

What Is the Effect of a Deemed Exchange?

Example 1--deemed exchange of a debt instrument: A debt instrument with a face value of $100,000 has an original maturity of 10 years and an original issue price of $100,000 After six years, the bank and the borrower significantly modify the instrument The MDI calls for the payment of interest at a rate exceeding the AFR for this type of debt instrument on the date of the modification.

Because the modified current interest rate is greater than the AFR, the amount realized is equal to the MDI's face value. This amount is used to determine gain or loss. The bank will recognize a taxable gain of $0 ($100,000 - $100,000 basis in loan) on the exchange.

Example 2--change in yield: A debt instrument with a face value of $100,000 has an original maturity of 10 years. Interest is paid annually at a fixed rate of 8%, with the principal balance of $100,000 to be paid at maturity. After six years, the bank and the borrower agree to reduce the fixed interest rate to 6% for the instruments remaining term. The AFR for this type of debt instrument was 8% for transactions occurring during the month of the loan modification.

The change in the interest rate of 200 basis points exceeds both 1/4 of 1% (25 basis points) and 5% of the original 8% yield (40 basis points). The change in interest rate thus is considered a significant modification resulting in a deemed exchange.

Because the modified current interest rate is less than the AFR, the bank needs to account for the new security under the OID rules. The present value of the new note using the 8% AFR is $90,754. Using this amount to determine gain or loss, the bank must recognize a taxable loss of $9,246 ($90,754 - $100,000 basis in loan). The difference between the MDI's face amount and its issue price is OID. Both parties need to use the OID rules to determine the amount of OID that they must recognize in subsequent periods.

Bad Debt Fix Might Not Benefit Community Banks

When a bank significantly modifies a debt instrument that it has previously charged off, wholly or partially, it may be required to recognize a gain under recently finalized Regs. Sec. 1.1001-3.

The Service recently issued temporary regulations under Sec. 166 to negate the gain recognized in certain circumstances from the deemed exchange. These regulations are effective for deemed exchanges that occur on or after Sept. 23, 1996.

Since Regs. Sec. 1.1001-3 is effective for alterations that occur on or after Sept. 24, 1996, banks may need to treat the modification as an exchange of the old debt instrument for a new MDI. The amount banks realize under the deemed exchange rules does not take into account the MDI's credit quality. As a result, banks often recognize a gain when they have a debt modification.

Before the Service issued Regs. Sec. 1.1001-3, banks often avoided this potential problem by not treating a debt modification as an exchange.

Taxpayers need to be aware of the potential tax liability associated with MDIs, if their bank uses the reserve method of accounting for bad debts. In fact, if the bank has built up bad debt reserves in the years since 1987 as a result of significant losses, taxpayers may end up with an increased current tax liability as a result of the new regulations.

Requirements for Deemed Charge-Offs

Temp. Regs. Sec. 1.166-3T provides banks with a deemed charge-off if they meet the following requirements:

* A partial worthlessness deduction was claimed in a prior tax year, and

* The prior charge-off met the normal partial worthlessness requirements.

The amount of the deemed charge-off is the amount by which the MDI's tax basis exceeds the greater of its fair market value (FMV) or the amount of the debt recorded on the bank's books and records (reduced as appropriate by specific loan loss allowances). The amount of the deemed charge-off also is limited to the amount of gain the bank has recognized under the deemed exchange.

The amount realized in a deemed exchange under the deemed exchange rules is the MDI's issue price, determined using the OID rules. The FMV of an MDI often is lower than its issue price, which could cause a bank to have to recognize a gain, as well as use a tax basis that exceeds the book basis for the MDI. The new temporary regulations try to remedy this problem by providing banks with a mechanism to write off additional tax basis to the extent the MDI exceeds the greater of FMV or book basis.

Does the Fix Included in the New Regs. Work?

For banks that use the specific charge-off method of accounting, the ability to write off the additional tax basis provides the same taxable income result as if the banks reduced the amount realized on the exchange to more closely resemble the MDI's FMV Banks can offset the recognition of taxable gain on the deemed exchange in many cases using a bad debt deduction of an equal or similar amount.

But banks that use a reserve method of accounting (generally, banks with assets of less than $500 million or thrifts) may not benefit from this regulatory solution. They may or may not be able to offset the recognition of a taxable gain on the deemed exchange by using an additional bad debt deduction; the deemed charge-off does not directly result in a bad debt deduction, but rather, decreases reserve method banks' bad debt reserve. The mechanics of this new regulation are illustrated in the example on page 86.

RELATED ARTICLE: Tax Clinic

Example: Deemed Exchange of a Partially Worthless Debt Instrument

Bank ABC issues a debt instrument with an original face value of $200,000 and a maturity of 10 years. After eight years, the bank determines that $60,000 of the debt instrument is partially worthless and charges this amount off on its books and records. (The remaining basis equals $140,000.) ABC significantly modifies the debt instrument as part of a debt workout the next year, when the instrument is still worth about $140,000. The MDI calls for the payment of interest at a rate exceeding the AFR for this type of debt instrument.

ABC uses the face amount of the note to determine its gain or loss because the modified current interest rate is greater than the AFR. ABC will recognize a taxable gain of $60,000 ($200,000 - $140,000) on the deemed exchange. It also claims a $60,000 charge-off under Temp. Regs. Sec. 1.166-3T. The charge-off equals the amount by which the MDI's initial tax basis ($200,000) exceeds the greater of its FMV ($140,000) or the carrying amount of the MDI on ABC's books and records ($140,000), reduced by any specific loan loss allowances.

If ABC's bad debt reserve after the deemed charge-off exceeds both its base-year reserve level and its experienced-based reserve level, a deemed charge-off will not result in any additional bad debt deduction. The chart below compares the effects of the new regulations on large banks versus small banks, using the facts of the example.

                                      Big Bank       Small Bank #1
Facts:
Deemed exchange gain @ 12/96          $ 60,000       $    60,000
Deemed charge-off @ 12/96               60,000            60,000
Average loans outstanding 1991-1996     N/A(1)       100,000,000
Loans outstanding @ 12/96               N/A(1)       100,000,000
Bad debt reserve @ 12/96
 before deemed charge-off               N/A(1)           100,000
Base-year reserve @ 12/96               N/A(1)            10,000
Experienced-based reserve @ 12/96
  before deemed charge-off              N/A(1)            25,000

Results:

Taxable income before deemed
  exchange and charge-off               200,000           200,000
Deemed exchange gain                     60,000            60,000
Increased bad debt deduction            (60,000)(1)             0(2)
Taxable income
  after debt modification              $200,000         $  260,000

                                           Small Bank #2
Facts:
Deemed exchange gain @ 12/96              $       60,000
Deemed charge-off @ 12/96                         60,000
Average loans outstanding 1991-1996          100,000,000
Loans outstanding @ 12/96                    100,000,000
Bad debt reserve @ 12/96
 before deemed charge-off                        100,000
Base-year reserve @ 12/96                         10,000
Experienced-based reserve @ 12/96
  before deemed charge-off                       100,000

Results:

Taxable income before deemed
  exchange and charge-off                       200,000
Deemed exchange gain                             60,000
Increased bad debt deduction                   (70,000)(3)
Taxable income
  after debt modification                   $   190,000

(1) Big Bank uses the specific charge-off method of accounting for bad debts because it has assets greater than $500,000,000. The deemed charged-off of $60,000 results in an additional bad debt deduction of $60,000.

(2) Small Bank #1 receives no benefit for the deemed charge-off of $60,000. The additional charge-off of $60,000 increases its six-year moving average experienced-based reserve by $10,000 ($60,000 / 6) to $35,000 and decreases its bad debt reserve by $60,000 to $40,000 ($100,000 - $60,000). No additional bad debt deduction results, because the bad debt reserve still exceeds both the base year reserve and the experienced-based reserve at 12/96.

(3) Small Bank #2 benefits from the deemed charge-off rule. The additional charge-off of $60,000 increases its experienced-based reserve by $10,000 / 6) to $110,000 and decreases its bad debt reserve by $60,000 to $40,000 ($100,000 - $60,000). An additional bad debt deduction of $70,000 ($110,000 -