Proposed regulations on debt modifications - are grandfathered earnings stripping obligations in jeopardy?

The so-called earnings stripping rules of Sec. 163(j), enacted in 1989, generally limit the deductibility of interest paid to a foreign related person by a domestic corporation. Interest paid on certain financial instruments issued before July 10, 1989 is generally exempt from these limitations. However, certain debt modifications may now subject these instruments to the vagaries of Sec. 163(j). Considering the multitude of debt workouts in recent months, companies with "grandfathered" debt obligations are well-advised to pay special attention to any modifications that may jeopardize their preferred status.

Prop. Regs. Sec. 1.163(j)-10(b)(1)(i) provides that "[i]nterest paid or accrued with respect to a fixed-term debt obligation outstanding on July 10, 1989, shall not be treated as disallowed interest expense, even though such interest is paid or accrued in a taxable year of the payor corporation beginning after July 10, 1989." Further exceptions are provided for certain obligations issued pursuant to written contracts binding on July 10, 1989.

Prop. Regs. Sec. 1.163(j)-10(b)(1)(iii) denies this so-called grandfather treatment for qualified obligations that are modified after July 10, 1989. A modification is defined as a revision (whether by renegotiation, assumption, reissuance or otherwise) in a manner that would be treated as a deemed exchange of debt instruments by the obligee under Sec. 1001.

Under Regs. Sec. 1.1001-1(a), gain or loss realized from the exchange of property for other property differing materially either in kind or in extent is treated as a taxable exchange. This definition however is very vague. Various IRS pronouncements and court opinions have generally attempted to cure this uncertainty, but unfortunately they have taken the position that even seemingly innocuous changes in an obligation will result in a taxable exchange.

Rev. Rul. 89-122 held that a reduction in the principal amount of a debt obligation would result in a material modification and consequently a taxable exchange. This ruling has been strongly criticized. It appears that, in substance, a reduction in the principal amount of a debt obligation by debt cancellation is not materially different from a prepayment of the debt by the obligor. Therefore, one should expect symmetry in their treatment.

In December 1992, the Service proposed new Regs. Sec. 1.1001-3 offering guidance on when a debt modification will result in a taxable exchange. Generally, these regulations will treat a change in a debt instrument as a taxable exchange if the change is a modification and the modification is significant.

A detailed discussion of the proposed regulations is beyond the scope of this article; however, a common theme may be extracted from the proposed regulations--the threshold for materiality has been lowered to make a mockery of the word "significant."

The following changes will constitute a significant modification: * A change in the yield. * A change in the timing and/or amounts of payments. * A change in the obligor or security. * A change in the nature of the debt instrument.

Any modification of a grandfathered debt instrument should be very carefully scrutinized in light of the proposed regulations. For example, the mere forgiveness of a portion of a debt's principal amount may constitute a substantial modification. The proposed regulations reach this result based on the principal that a fluctuation of the annual yield on a debt instrument by more than 25 basis points (0.25%) is a substantial modification. When a portion of a debt instrument is forgiven, the yield is recalculated based on the adjusted issue price. This method will almost always result in a yield fluctuation of greater than 25 basis points. The proposed regulations provide that the adjusted issue price may be increased or decreased to take into account payments made as consideration for the modification, for purposes of calculating the yield. Unfortunately, no adjustment to the issue price is permissible for debt cancellation.

Since prepayment of a debt obligation is specifically allowed, it appears that proper tax planning may circumvent the harsh effects of the regulations. Rather than canceling a portion of a debt instrument, a foreign parent may increase the capital of the domestic subsidiary which may allow the subsidiary to prepay its debt at a future date. Of course, if the two transactions are sufficiently linked together, the Service may take the position that in substance the transaction is nothing more than a debt forgiveness and, therefore, a substantial modification has occurred. (Note: At the time this article was written, the Clinton administration had proposed legislation that would eliminate the grandfather protection for financial instruments issued prior to July 10, 1989.)

From Michael S. Burke, J.D., Washington, D.C.