1.1001-6: Modifying Distressed Government Debt Rules
Explore the tax treatment for modifications to government debt, detailing the regulatory framework that provides relief for bondholders of distressed issuers.
A Treasury Regulation is an official interpretation by the Internal Revenue Service (IRS) of the Internal Revenue Code. When a government entity, such as a municipality, experiences financial distress, it may need to change the terms of its outstanding bonds to avoid default. These changes can range from altering interest rates to extending repayment dates.
Under federal tax law, substantially altering the terms of a government bond can be a taxable event for the bondholder. The law may treat the altered bond as a new security that has been exchanged for the old one. These modifications are governed by Treasury Regulation § 1.1001-3, which is important for workouts involving struggling public entities.
The General Rule for Debt Modification
The foundational tax principle is that a “significant modification” of a debt instrument results in a deemed exchange of the original debt for a new one. For the bondholder, this deemed exchange is a taxable event, potentially triggering a gain or loss. This applies to any alteration of a legal right or obligation of the issuer or holder.
A “modification” is broadly defined as nearly any change to the legal rights or obligations under the debt agreement. For a modification to be “significant,” it must be economically meaningful. For example, a change in the bond’s yield is significant if it varies by more than the greater of 25 basis points (0.25%) or 5% of the original yield.
Other changes considered significant include a material deferral of scheduled payments or a change in the obligor. However, the regulations provide “safe harbors” for modifications that are not considered significant. A deferral is not a significant modification if the deferred payments are unconditionally payable no later than the end of a safe-harbor period, which is the lesser of five years or 50% of the original term of the instrument.
Tax Implications When a Modification is Significant
If a modification to a government bond is significant and does not qualify for a safe harbor, the transaction is treated as a taxable exchange for the bondholder. The bondholder is treated as having sold the original bond in exchange for the newly modified bond, triggering a capital gain or loss. The gain or loss is the difference between the bondholder’s adjusted basis in the original bond and the “issue price” of the new one. The adjusted basis is what the investor paid for the bond, adjusted for any amortized premium or discount.
If the debt is publicly traded, the issue price is the fair market value of the modified bond on the date of the modification. If the new bond’s issue price is greater than the holder’s basis, the holder recognizes a capital gain. If the issue price is less than the basis, a capital loss is recognized, creating a potential tax liability even though no cash was received.