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IRS rules on significant modification test for contingent payment debt

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IRS rules on significant modification test for contingent payment debtThe IRS ruled in a private letter ruling (PLR 201546009) released Nov. 13 that a consent fee paid by a debtor to its creditors was a modification of the underlying debt and must be tested as a significant modification under Treas. Reg. Sec. 1.1001-3.  

In PLR 201431003, a corporation (taxpayer) had issued certain exchangeable debentures (the notes), which constituted contingent payment debt instruments (CPDIs) as defined in Treas. Reg. Sec. 1.1275-4. Under Treas. Reg. Sec. 1.1275-4(b), taxpayer’s interest expense related to the notes was accrued by reference to a comparable yield and projected payment schedule.

Taxpayer intended to effect a spinoff transaction. In light of previous litigation related to an earlier transaction, taxpayer wanted to negotiate a one-time payment in exchange for the consent to the spinoff of the holders of the notes (the consent payment).

Under Treas. Reg. Sec. 1.1001-3, a modification of a debt generally means any alterations, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt with certain exceptions. While a debt modification that is not a “significant modification” does not result in an exchange, Treas. Reg. Sec. 1.1001-3(b) provides that a significant modification results in a deemed exchange of the existing debt for a new debt.

Whether a debt modification constitutes a significant modification is based on the facts and circumstances. See Treas. Reg. Sec. 1.1001-3(e)(1). However, Treas. Reg. Sec. 1.1001-3(e)(2) provides a bright-line test that a significant modification occurs when a debt modification changes the yield of a debt by more than the greater of: (i) one-fourth of 1% or (ii) 5% of the annual yield of the unmodified debt.

Because the consent payment would result in the noteholders’ receiving more money than they otherwise would have under the terms of the notes, the consent payment would change the yield on the notes. Therefore, the IRS ruled that the consent payment would constitute a debt modification of the notes that must be tested to be a significant modification under Treas. Reg. Sec. 1.1001-3.

For debt instruments that are not CPDIs, whether a change in yield results in a significant modification is tested under Treas. Reg. Sec. 1.1001-3(e)(2), as noted above. However, because the notes constituted CPDIs, the general test under Treas. Reg. Sec. 1.1001-3(e)(1) applies, which is based on facts and circumstances.

Notwithstanding that the general test under Treas. Reg. Sec. 1.1001-3(e)(1) applies, the IRS ruled that it is appropriate to apply a test similar to Treas. Reg. Sec. 1.1001-3(e)(2) to the notes. Specifically, in applying a test similar to Treas. Reg. Sec. 1.1001-3(e)(2), the IRS ruled that the taxpayer should compare the “go-forward yield” (i.e., the yield of a hypothetical debt on the modification date based on the projected payment schedule including the consent payment) (emphasis added) and the original yield (i.e., the comparable yield of the notes immediately before the consent payment).

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