Final rules on debt changes, NPC assignments.

The IRS has released final regulations under Secs. 166 and 1001, providing guidance on bad debt deductions for modified debt and the tax impact of assignments of notional principal contracts (NPCs) on nonassigning counterparties.

Sec. 166 Regulations

The final Sec. 166 regulations generally are the same as temporary regulations issued in June 1996, which provided a deemed charge-off for modified debt in certain circumstances. Under the regulations, a taxpayer is deemed to have charged off a modified debt if: (1) the debt was significantly modified during the tax year and the modification resulted in gain recognition by the taxpayer under Regs. Sec. 1.1001-1(a); (2) the taxpayer claimed a deduction for partial worthlessness of the debt in any prior tax year; and (3) each prior charge-off and deduction for bad debts met the general requirements of Regs. Sec. 1.166-30)(1) and (2) (requiring the deduction to be applicable to specific debts and claimed only to the extent charged off in the tax year).

Under Sec. 1660)(2) and Regs. Sec. 1.166-3(a), a deduction for a partially worthless debt is allowable only to the extent the debt is charged off in the tax year; the amount of the deduction equals the excess of the adjusted debt's basis over the amount recoverable. The charge-off requirement is satisfied for a debt when a portion of the debt is removed from a taxpayer's books and records. Debts typically are charged off by reducing their book bases.

Taxpayers required to recognize gain on a modification under Sec. 1001 increase their tax basis in the debt, but are not allowed to make a corresponding increase in the debt's book basis. However, the gain (i.e., the excess of the new debt's issue price over the original debt's adjusted issue price) is attributable, in part, to the fact that the taxpayer previously claimed a deduction for partial worthlessness (thus reducing its basis in the debt), and the modification does not alter the fact that a portion of the debt remains uncollectible. Thus, the argument can be made that the taxpayer should be allowed to offset a portion of the gain with a corresponding bad debt deduction.

A deemed charge-off allows a taxpayer to take a new charge-off for preexisting worthlessness that economically was not restored when the terms of the debt instrument were subsequently modified. The deemed charge-off is the amount by which the debt's tax basis exceeds the greater of its fair market value or the amount (reduced by specific reserves) recorded on the taxpayer's books and records. In no event, however, can the deemed charge-off exceed the gain recognized on the modification.

Notably, the Service rejected requests for deemed charge-off relief when a taxpayer acquired, at a discount, debt that had been charged off previously (i.e., by another taxpayer), modified the debt and then recognized gain on the modification. The IRS position is that such gain is properly attributable to market discount, not to previous charge-offs, and that such an expansion of the deemed charge-off rule would be beyond the regulation's intended scope. Accordingly, taxpayers acquiring debts in discount purchase transactions must continue to rely on other provisions or use careful structuring in seeking to avoid or eliminate gain recognition on workouts.

The Service also rejected extending the regulations to situations in which book basis is greater than tax basis due to nonaccrual-interest status. Again, such an extension was viewed to be beyond the regulation's scope. The final Sec. 166 regulations are effective for significant modifications of debt instruments occurring after Sept. 22, 1996.

Sec. 1001 Regulations

Under certain conditions, the final Sec. 1001 regulations provide that an assignment of an NPC is not treated as a deemed exchange by the nonassigning party of the original contract for a new contract that differs materially, either in kind or extent; thus, it does not give rise to a realized gain or loss under Regs. Sec. 1.1001-1 (a) to the nonassigning counterparty. This treatment applies if the assigning party and the party to which the contract is assigned are both dealers in NPCs (as defined in Regs. Sec. 1.446-3(c)(4)(iii)) and the terms of the contract permit the assignment.

Because standard swap contracts generally provide for assignment (with consent), this provision should apply to most dealer-to-dealer assignments. The Sec. 1001 regulations apply to interest rate swaps, commodity swaps and other NPCs occurring after Sept. 22, 1996.