No federal income tax consequences for release of co-obligor on debt instrument.

In Letter Ruling 200047046, the Service ruled that the release of a subsidiary as a co-obligor on a debt instrument had no Federal income tax consequences. This ruling is the first published guidance on the payment expectations test under the Regs. Sec. 1.1001-3 debt modification regulations.

In 1996, the IRS issued regulations under Sec. 1001 for determining when a modification of the terms of an outstanding debt instrument would be considered an exchange of the original debt for a new instrument. Regs. Sec. 1.1001-3 was issued in response to uncertainty in the wake of the Supreme Court holding in Cottage Savings Ass'n, 499 US 554 (1991), and replaced a patchwork of case law and revenue rulings.

If there is an exchange of debt instruments, the issuer may have cancellation of indebtedness income under Sec. 108(e)(10) or a repurchase premium under Regs. Sec. 1.163-7(c). In an exchange, holders may have gain or loss, which would be recognized unless a nonrecognition provision applies.

The regulations incorporated a new payment expectations test for several types of modifications.

In the ruling, a holding company had issued debt instruments with its wholly owned operating subsidiary as a co-obligor; the subsidiary was jointly and severally liable for all payments due under such instruments. The debt covenants restricted the amount of debt (other than certain short-term debt) that the parent and subsidiary could incur to a certain percentage of the parent's net tangible assets.

If the subsidiary remained as co-obligor, the company anticipated that it would be required to include expanded financial information in its next annual report (Form 10-K), when proposed Securities and Exchange Commission (SEC) rules became final.

To reduce this administrative burden and avoid possible confusion among investors, the parent proposed to remove its operating subsidiary on all of the debt. Each instrument permitted the parent to remove the subsidiary as co-obligor under certain conditions, including removal as co-obligor on all other debt instruments at approximately the same time.

Applying the payment expectations test in Regs. Sec. 1.1001-3 for the first time in a published ruling, the Service ruled that the release of the co-obligor did not result in a change in payment expectations or in a significant modification of the debt instruments.

Regs. Sec. 1.1001-3 provides that a "significant modification" of the legal rights or obligations under a debt is an exchange of a new instrument for the original instrument. The regulation requires a two-part analysis. First, it provides rules to determine if a modification of the debt occurred. Second, if there was a modification, the regulations provide both a general rule and specific rules for determining if the modification was "significant."

Generally, changes that occur by operations of the instrument's term are not debt modifications (Regs. Sec. 1.1001-3(c)(1)). A change in the obligor, including the addition or deletion of a co-obligor, is an exception to this rule (Regs. Sec. 1.1001-3(c)(2)(i)). Thus, the release of a co-obligor is considered a modification even though the parent did not need the holders' consent.

Under Regs. Sec. 1.1001-3(e)(4), several types of modifications are significant if the modification results in a "change in payment expectations." This test applies to changes in co-obligors, certain collateral and obligors in reorganizations to which Sec. 381(a) applies.

Regs. Sec. 1.1001-3(e)(4)(vi) provides a two-part test to determine if a modification results in a change in payment expectations. First, there must be either a substantial impairment or enhancement of the obligor's capacity to meet the payment obligations. Second, the capacity must change from adequate to primarily speculative or vice versa. The terms "capacity," "adequate" and "speculative" are used by rating agencies in describing the credit ratings-assigned to companies. Thus, as a rough rule, a modification of a debt will not result in a change in payment expectations for a debt that remains at investment grade or below after the modification.

The letter ruling focused on the earnings and assets available to meet the obligations under the debts. Although the subsidiary was removed as a co-obligor, the covenants that continued in force effectively allowed the subsidiary's earnings and assets to continue to provide capacity toward the parent's debt. The ruling concluded that the removal of the subsidiary did not result in a change in payment expectations.

Thus, the deletion of a subsidiary as a co-obligor can allow companies in certain cases to simplify SEC reporting without Federal income tax consequences to the company or its debt holders.

FROM THOMAS J. KELLY, J.D., LL.M., WASHINGTON, DC