In general, an exchange of property for other property differing materially either in kind or in extent is treated as a taxable exchange for U.S. federal income tax purposes. Special rules govern whether a modification of the terms of a debt instrument results in a taxable exchange. These rules apply to any modification of a debt instrument, regardless of the form of the modification. For example, the rules apply to an exchange of a new instrument for an existing debt instrument, or to an amendment of an existing debt instrument. A modification of a debt instrument results in a taxable exchange of the original debt instrument for the modified instrument if the modification is a "significant modification." In general, unless a modification falls under one of five enumerated categories of modifications, the 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. Special rules apply to modifications that fall under any of the five enumerated categories of changes. Two commonly-encountered modifications that fall under the enumerated categories are modifications that change the yield of a debt instrument and modifications that extend the maturity date of the debt instrument.

Change in Yield

Generally speaking, the change in the yield of a debt instrument is a significant modification if the yield on the modified instrument1 varies from the yield on the unmodified instrument (determined as of the date of the modification) by more than the greater of (A) 1/4 of 1% (25 basis points); or (B) 5% of the annual yield of the unmodified instrument.

For example, if a 10-year debt instrument originally issued for $100x and having a stated redemption price at maturity for $100x that pays interest at 10% per annum is modified at the end of the 5th year by reducing the principal to $80x, there would be a significant modification because the yield on the modified debt instrument would be approximately 4.3%.

Extension of Maturity

A modification that changes the timing of payments due under a debt instrument is a significant modification if it results in the material deferral of scheduled payments. The deferral may occur either through an extension of the final maturity date of an instrument or through a deferral of payments due prior to maturity. The materiality of the deferral depends on all the facts and circumstances, including the length of the deferral, the original term of the instrument and the amounts of the payments that are deferred.

The deferral of one or more scheduled payments within a prescribed "safeharbor period" (described below) is not a material deferral if the deferred payments are unconditionally payable no later than at the end of the safe-harbor period. The safe-harbor period 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.

For example, if a 10-year zero-coupon bond is modified by extending the maturity an additional 2 years (without increasing the stated redemption price at maturity), the deferral would fall under the safe-harbor period (i.e., it is less than five years) and would not be a significant modification under the extension of maturity test (but note that the bond must also be tested under the change in yield test, described above).


1 The yield of the modified debt instrument is the annual yield of a debt instrument with (i) an issue price equal to the adjusted issue price of the unmodified instrument on the date of the modification (increased by any accrued but unpaid interest and decreased by any accrued bond issuance premium not yet taken into account, and increased or decreased, respectively, to reflect payments made to the issuer or to the holder as consideration for the modification); and (ii) payments equal to the payments on the modified debt instrument from the date of the modification.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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