[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1001-3]

[Page 17-26]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1001-3  Modifications of debt instruments.

    (a) Scope--(1) In general. This section provides rules for 
determining whether a modification of the terms of a debt instrument 
results in an exchange for purposes of Sec. 1.1001-1(a). This section 
applies to any modification of a debt instrument, regardless of the form 
of the modification. For example, this section applies to an exchange of 
a new instrument for an existing debt instrument, or to an amendment of 
an existing debt instrument. This section also applies to a modification 
of a debt instrument that the issuer and holder accomplish indirectly 
through one or more transactions with third parties. This section, 
however, does not apply to exchanges of debt instruments between 
holders.
    (2) Qualified tender bonds. This section does not apply for purposes 
of determining whether tax-exempt bonds that are qualified tender bonds 
are reissued for purposes of sections 103 and 141 through 150.
    (b) General rule. For purposes of Sec. 1.1001-1(a), a significant 
modification of a debt instrument, within the meaning of this section, 
results in an exchange of the original debt instrument for a modified 
instrument that differs materially either in kind or in extent. A 
modification that is not a significant modification is not an exchange 
for purposes of Sec. 1.1001-1(a). Paragraphs (c) and (d) of this 
section define the term modification and contain examples illustrating 
the application of the rule. Paragraphs (e) and (f) of this section 
provide rules for determining when a modification is a significant 
modification. Paragraph (g) of this section contains examples 
illustrating the application of the rules in paragraphs (e) and (f) of 
this section.
    (c) Modification defined--(1) In general--(i) Alteration of terms. A 
modification means any alteration, 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 instrument, whether the alteration is evidenced by an 
express agreement (oral or written), conduct of the parties, or 
otherwise.
    (ii) Alterations occurring by operation of the terms of a debt 
instrument. Except as provided in paragraph (c)(2) of this section, an 
alteration of a legal right or obligation that occurs by operation of 
the terms of a debt instrument is not a modification. An alteration that 
occurs by operation of the terms may occur automatically (for example, 
an annual resetting of the interest rate based on the value of an index 
or a specified increase in the interest rate if the value of the 
collateral declines from a specified level) or may occur as a result of 
the exercise of an option provided to an issuer or a holder to change a 
term of a debt instrument.
    (2) Exceptions. The alterations described in this paragraph (c)(2) 
are modifications, even if the alterations occur by operation of the 
terms of a debt instrument.
    (i) Change in obligor or nature of instrument. An alteration that 
results in the substitution of a new obligor, the addition or deletion 
of a co-obligor, or a change (in whole or in part) in the recourse 
nature of the instrument (from

[[Page 18]]

recourse to nonrecourse or from nonrecourse to recourse) is a 
modification.
    (ii) Property that is not debt. An alteration that results in an 
instrument or property right that is not debt for Federal income tax 
purposes is a modification unless the alteration occurs pursuant to a 
holder's option under the terms of the instrument to convert the 
instrument into equity of the issuer (notwithstanding paragraph 
(c)(2)(iii) of this section).
    (iii) Certain alterations resulting from the exercise of an option. 
An alteration that results from the exercise of an option provided to an 
issuer or a holder to change a term of a debt instrument is a 
modification unless--
    (A) The option is unilateral (as defined in paragraph (c)(3) of this 
section); and
    (B) In the case of an option exercisable by a holder, the exercise 
of the option does not result in (or, in the case of a variable or 
contingent payment, is not reasonably expected to result in) a deferral 
of, or a reduction in, any scheduled payment of interest or principal.
    (3) Unilateral option. For purposes of this section, an option is 
unilateral only if, under the terms of an instrument or under applicable 
law--
    (i) There does not exist at the time the option is exercised, or as 
a result of the exercise, a right of the other party to alter or 
terminate the instrument or put the instrument to a person who is 
related (within the meaning of section 267(b) or section 707(b)(1)) to 
the issuer;
    (ii) The exercise of the option does not require the consent or 
approval of--
    (A) The other party;
    (B) A person who is related to that party (within the meaning of 
section 267(b) or section 707(b)(1)), whether or not that person is a 
party to the instrument; or
    (C) A court or arbitrator; and
    (iii) The exercise of the option does not require consideration 
(other than incidental costs and expenses relating to the exercise of 
the option), unless, on the issue date of the instrument, the 
consideration is a de minimis amount, a specified amount, or an amount 
that is based on a formula that uses objective financial information (as 
defined in Sec. 1.446-3(c)(4)(ii)).
    (4) Failure to perform--(i) In general. The failure of an issuer to 
perform its obligations under a debt instrument is not itself an 
alteration of a legal right or obligation and is not a modification.
    (ii) Holder's temporary forbearance. Notwithstanding paragraph 
(c)(1) of this section, absent a written or oral agreement to alter 
other terms of the debt instrument, an agreement by the holder to stay 
collection or temporarily waive an acceleration clause or similar 
default right (including such a waiver following the exercise of a right 
to demand payment in full) is not a modification unless and until the 
forbearance remains in effect for a period that exceeds--
    (A) Two years following the issuer's initial failure to perform; and
    (B) Any additional period during which the parties conduct good 
faith negotiations or during which the issuer is in a title 11 or 
similar case (as defined in section 368(a)(3)(A)).
    (5) Failure to exercise an option. If a party to a debt instrument 
has an option to change a term of an instrument, the failure of the 
party to exercise that option is not a modification.
    (6) Time of modification--(i) In general. Except as provided in this 
paragraph (c)(6), an agreement to change a term of a debt instrument is 
a modification at the time the issuer and holder enter into the 
agreement, even if the change in the term is not immediately effective.
    (ii) Closing conditions. If the parties condition a change in a term 
of a debt instrument on reasonable closing conditions (for example, 
shareholder, regulatory, or senior creditor approval, or additional 
financing), a modification occurs on the closing date of the agreement. 
Thus, if the reasonable closing conditions do not occur so that the 
change in the term does not become effective, a modification does not 
occur.
    (iii) Bankruptcy proceedings. If a change in a term of a debt 
instrument occurs pursuant to a plan of reorganization in a title 11 or 
similar case (within the meaning of section 368(a)(3)(A)), a 
modification occurs upon the effective date of the plan.

[[Page 19]]

Thus, unless the plan becomes effective, a modification does not occur.
    (d) Examples. The following examples illustrate the provisions of 
paragraph (c) of this section:

    Example 1. Reset bond. A bond provides for the interest rate to be 
reset every 49 days through an auction by a remarketing agent. The reset 
of the interest rate occurs by operation of the terms of the bond and is 
not an alteration described in paragraph (c)(2) of this section. Thus, 
the reset of the interest rate is not a modification.
    Example 2. Obligation to maintain collateral. The original terms of 
a bond provide that the bond must be secured by a certain type of 
collateral having a specified value. The terms also require the issuer 
to substitute collateral if the value of the original collateral 
decreases. Any substitution of collateral that is required to maintain 
the value of the collateral occurs by operation of the terms of the bond 
and is not an alteration described in paragraph (c)(2) of this section. 
Thus, such a substitution of collateral is not a modification.
    Example 3. Alteration contingent on an act of a party. The original 
terms of a bond provide that the interest rate is 9 percent. The terms 
also provide that, if the issuer files an effective registration 
statement covering the bonds with the Securities and Exchange 
Commission, the interest rate will decrease to 8 percent. If the issuer 
registers the bond, the resulting decrease in the interest rate occurs 
by operation of the terms of the bond and is not an alteration described 
in paragraph (c)(2) of this section. Thus, such a decrease in the 
interest rate is not a modification.
    Example 4. Substitution of a new obligor occurring by operation of 
the terms of the debt instrument. Under the original terms of a bond 
issued by a corporation, an acquirer of substantially all of the 
corporation's assets may assume the corporation's obligations under the 
bond. Substantially all of the corporation's assets are acquired by 
another corporation and the acquiring corporation becomes the new 
obligor on the bond. Under paragraph (c)(2)(i) of this section, the 
substitution of a new obligor, even though it occurs by operation of the 
terms of the bond, is a modification.
    Example 5. Defeasance with release of covenants. (i) A corporation 
issues a 30-year, recourse bond. Under the terms of the bond, the 
corporation may secure a release of the financial and restrictive 
covenants by placing in trust government securities as collateral that 
will provide interest and principal payments sufficient to satisfy all 
scheduled payments on the bond. The corporation remains obligated for 
all payments, including the contribution of additional securities to the 
trust if necessary to provide sufficient amounts to satisfy the payment 
obligations. Under paragraph (c)(3) of this section, the option to 
defease the bond is a unilateral option.
    (ii) The alterations occur by operation of the terms of the debt 
instrument and are not described in paragraph (c)(2) of this section. 
Thus, such a release of the covenants is not a modification.
    Example 6. Legal defeasance. Under the terms of a recourse bond, the 
issuer may secure a release of the financial and restrictive covenants 
by placing in trust government securities that will provide interest and 
principal payments sufficient to satisfy all scheduled payments on the 
bond. Upon the creation of the trust, the issuer is released from any 
recourse liability on the bond and has no obligation to contribute 
additional securities to the trust if the trust funds are not sufficient 
to satisfy the scheduled payments on the bond. The release of the issuer 
is an alteration described in paragraph (c)(2)(i) of this section, and 
thus is a modification.
    Example 7. Exercise of an option by a holder that reduces amounts 
payable. (i) A financial institution holds a residential mortgage. Under 
the original terms of the mortgage, the financial institution has an 
option to decrease the interest rate. The financial institution 
anticipates that, if market interest rates decline, it may exercise this 
option in lieu of the mortgagor refinancing with another lender.
    (ii) The financial institution exercises the option to reduce the 
interest rate. The exercise of the option results in a reduction in 
scheduled payments and is an alteration described in paragraph 
(c)(2)(iii) of this section. Thus, the change in interest rate is a 
modification.
    Example 8. Conversion of adjustable rate to fixed rate mortgage. (i) 
The original terms of a mortgage provide for a variable interest rate, 
reset annually based on the value of an objective index. Under the terms 
of the mortgage, the mortgagor may, upon the payment of a fee equal to a 
specified percentage of the outstanding principal amount of the 
mortgage, convert to a fixed rate of interest as determined based on the 
value of a second objective index. The exercise of the option does not 
require the consent or approval of any person or create a right of the 
holder to alter the terms of, or to put, the instrument.
    (ii) Because the required consideration to exercise the option is a 
specified amount fixed on the issue date, the exercise of the option is 
unilateral as defined in paragraph (c)(3) of this section. The 
conversion to a fixed rate of interest is not an alteration described in 
paragraph (c)(2) of this section. Thus, the change in the type of 
interest rate occurs by operation of the terms of the instrument and is 
not a modification.

[[Page 20]]

    Example 9. Holder's option to increase interest rate. (i) A 
corporation issues an 8-year note to a bank in exchange for cash. Under 
the terms of the note, the bank has the option to increase the rate of 
interest by a specified amount upon a certain decline in the 
corporation's credit rating. The bank's right to increase the interest 
rate is a unilateral option as described in paragraph (c)(3) of this 
section.
    (ii) The credit rating of the corporation declines below the 
specified level. The bank exercises its option to increase the rate of 
interest. The increase in the rate of interest occurs by operation of 
the terms of the note and does not result in a deferral or a reduction 
in the scheduled payments or any other alteration described in paragraph 
(c)(2) of this section. Thus, the change in interest rate is not a 
modification.
    Example 10. Issuer's right to defer payment of interest. A 
corporation issues a 5-year note. Under the terms of the note, interest 
is payable annually at the rate of 10 percent. The corporation, however, 
has an option to defer any payment of interest until maturity. For any 
payments that are deferred, interest will compound at a rate of 12 
percent. The exercise of the option, which results in the deferral of 
payments, does not result from the exercise of an option by the holder. 
The exercise of the option occurs by operation of the terms of the debt 
instrument and is not a modification.
    Example 11. Holder's option to grant deferral of payment. (i) A 
corporation issues a 10-year note to a bank in exchange for cash. 
Interest on the note is payable semi-annually. Under the terms of the 
note, the bank may grant the corporation the right to defer all or part 
of the interest payments. For any payments that are deferred, interest 
will compound at a rate 150 basis points greater than the stated rate of 
interest.
    (ii) The corporation encounters financial difficulty and is unable 
to satisfy its obligations under the note. The bank exercises its option 
under the note and grants the corporation the right to defer payments. 
The exercise of the option results in a right of the corporation to 
defer scheduled payments and, under paragraph (c)(3)(i) of this section, 
is not a unilateral option. Thus, the alteration is described in 
paragraph (c)(2)(iii) of this section and is a modification.
    Example 12. Alteration requiring consent. The original terms of a 
bond include a provision that the issuer may extend the maturity of the 
bond with the consent of the holder. Because any extension pursuant to 
this term requires the consent of both parties, such an extension does 
not occur by the exercise of a unilateral option (as defined in 
paragraph (c)(3) of this section) and is a modification.
    Example 13. Waiver of an acceleration clause. Under the terms of a 
bond, if the issuer fails to make a scheduled payment, the full 
principal amount of the bond is due and payable immediately. Following 
the issuer's failure to make a scheduled payment, the holder temporarily 
waives its right to receive the full principal for a period ending one 
year from the date of the issuer's default to allow the issuer to obtain 
additional financial resources. Under paragraph (c)(4)(ii) of this 
section, the temporary waiver in this situation is not a modification. 
The result would be the same if the terms provided the holder with the 
right to demand the full principal amount upon the failure of the issuer 
to make a scheduled payment and, upon such a failure, the holder 
exercised that right and then waived the right to receive the payment 
for one year.

    (e) Significant modifications. Whether the modification of a debt 
instrument is a significant modification is determined under the rules 
of this paragraph (e). Paragraph (e)(1) of this section provides a 
general rule for determining the significance of modifications not 
otherwise addressed in this paragraph (e). Paragraphs (e) (2) through 
(6) of this section provide specific rules for determining the 
significance of certain types of modifications. Paragraph (f) of this 
section provides rules of application, including rules for modifications 
that are effective on a deferred basis or upon the occurrence of a 
contingency.
    (1) General rule. Except as otherwise provided in paragraphs (e)(2) 
through (e)(6) of this section, a 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. In making a determination under 
this paragraph (e)(1), all modifications to the debt instrument (other 
than modifications subject to paragraphs (e) (2) through (6) of this 
section) are considered collectively, so that a series of such 
modifications may be significant when considered together although each 
modification, if considered alone, would not be significant.
    (2) Change in yield--(i) Scope of rule. This paragraph (e)(2) 
applies to debt instruments that provide for only fixed payments, debt 
instruments with alternative payment schedules subject to Sec. 1.1272-
1(c), debt instruments that provide for a fixed yield subject to Sec. 
1.1272-1(d) (such as certain demand loans), and variable rate debt 
instruments.

[[Page 21]]

Whether a change in the yield of other debt instruments (for example, a 
contingent payment debt instrument) is a significant modification is 
determined under paragraph (e)(1) of this section.
    (ii) In general. A change in the yield of a debt instrument is a 
significant modification if the yield computed under paragraph 
(e)(2)(iii) of this section varies from the annual yield on the 
unmodified instrument (determined as of the date of the modification) by 
more than the greater of--
    (A) \1/4\ of one percent (25 basis points); or
    (B) 5 percent of the annual yield of the unmodified instrument (.05 
x annual yield).
    (iii) Yield of the modified instrument--(A) In general. The yield 
computed under this paragraph (e)(2)(iii) is the annual yield of a debt 
instrument with--
    (1) 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
    (2) Payments equal to the payments on the modified debt instrument 
from the date of the modification.
    (B) Prepayment penalty. For purposes of this paragraph (e)(2)(iii), 
a commercially reasonable prepayment penalty for a pro rata prepayment 
(as defined in Sec. 1.1275-2(f)) is not consideration for a 
modification of a debt instrument and is not taken into account in 
determining the yield of the modified instrument.
    (iv) Variable rate debt instruments. For purposes of this paragraph 
(e)(2), the annual yield of a variable rate debt instrument is the 
annual yield of the equivalent fixed rate debt instrument (as defined in 
Sec. 1.1275-5(e)) which is constructed based on the terms of the 
instrument (either modified or unmodified, whichever is applicable) as 
of the date of the modification.
    (3) Changes in timing of payments--(i) In general. A modification 
that changes the timing of payments (including any resulting change in 
the amount 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, the amounts of the payments that are 
deferred, and the time period between the modification and the actual 
deferral of payments.
    (ii) Safe-harbor period. The deferral of one or more scheduled 
payments within the safe-harbor period 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 percent of the original 
term of the instrument. For purposes of this paragraph (e)(3)(ii), the 
term of an instrument is determined without regard to any option to 
extend the original maturity and deferrals of de minimis payments are 
ignored. If the period during which payments are deferred is less than 
the full safe-harbor period, the unused portion of the period remains a 
safe-harbor period for any subsequent deferral of payments on the 
instrument.
    (4) Change in obligor or security--(i) Substitution of a new obligor 
on recourse debt instruments--(A) In general. Except as provided in 
paragraph (e)(4)(i) (B), (C), or (D) of this section, the substitution 
of a new obligor on a recourse debt instrument is a significant 
modification.
    (B) Section 381(a) transaction. The substitution of a new obligor is 
not a significant modification if the acquiring corporation (within the 
meaning of section 381) becomes the new obligor pursuant to a 
transaction to which section 381(a) applies, the transaction does not 
result in a change in payment expectations, and the transaction (other 
than a reorganization within the meaning of

[[Page 22]]

section 368(a)(1)(F)) does not result in a significant alteration.
    (C) Certain asset acquisitions. The substitution of a new obligor is 
not a significant modification if the new obligor acquires substantially 
all of the assets of the original obligor, the transaction does not 
result in a change in payment expectations, and the transaction does not 
result in a significant alteration.
    (D) Tax-exempt bonds. The substitution of a new obligor on a tax-
exempt bond is not a significant modification if the new obligor is a 
related entity to the original obligor as defined in section 
168(h)(4)(A) and the collateral securing the instrument continues to 
include the original collateral.
    (E) Significant alteration. For purposes of this paragraph (e)(4), a 
significant alteration is an alteration that would be a significant 
modification but for the fact that the alteration occurs by operation of 
the terms of the instrument.
    (F) Section 338 election. For purposes of this section, an election 
under section 338 following a qualified stock purchase of an issuer's 
stock does not result in the substitution of a new obligor.
    (G) Bankruptcy proceedings. For purposes of this section, the filing 
of a petition in a title 11 or similar case (as defined in section 
368(a)(3)(A)) by itself does not result in the substitution of a new 
obligor.
    (ii) Substitution of a new obligor on nonrecourse debt instruments. 
The substitution of a new obligor on a nonrecourse debt instrument is 
not a significant modification.
    (iii) Addition or deletion of co-obligor. The addition or deletion 
of a co-obligor on a debt instrument is a significant modification if 
the addition or deletion of the co-obligor results in a change in 
payment expectations. If the addition or deletion of a co-obligor is 
part of a transaction or series of related transactions that results in 
the substitution of a new obligor, however, the transaction is treated 
as a substitution of a new obligor (and is tested under paragraph 
(e)(4)(i)) of this section rather than as an addition or deletion of a 
co-obligor.
    (iv) Change in security or credit enhancement--(A) Recourse debt 
instruments. A modification that releases, substitutes, adds or 
otherwise alters the collateral for, a guarantee on, or other form of 
credit enhancement for a recourse debt instrument is a significant 
modification if the modification results in a change in payment 
expectations.
    (B) Nonrecourse debt instruments. A modification that releases, 
substitutes, adds or otherwise alters a substantial amount of the 
collateral for, a guarantee on, or other form of credit enhancement for 
a nonrecourse debt instrument is a significant modification. A 
substitution of collateral is not a significant modification, however, 
if the collateral is fungible or otherwise of a type where the 
particular units pledged are unimportant (for example, government 
securities or financial instruments of a particular type and rating). In 
addition, the substitution of a similar commercially available credit 
enhancement contract is not a significant modification, and an 
improvement to the property securing a nonrecourse debt instrument does 
not result in a significant modification.
    (v) Change in priority of debt. A change in the priority of a debt 
instrument relative to other debt of the issuer is a significant 
modification if it results in a change in payment expectations.
    (vi) Change in payment expectations--(A) In general. For purposes of 
this section, a change in payment expectations occurs if, as a result of 
a transaction--
    (1) There is a substantial enhancement of the obligor's capacity to 
meet the payment obligations under a debt instrument and that capacity 
was primarily speculative prior to the modification and is adequate 
after the modification; or
    (2) There is a substantial impairment of the obligor's capacity to 
meet the payment obligations under a debt instrument and that capacity 
was adequate prior to the modification and is primarily speculative 
after the modification.
    (B) Obligor's capacity. The obligor's capacity includes any source 
for payment, including collateral, guarantees, or other credit 
enhancement.
    (5) Changes in the nature of a debt instrument--(i) Property that is 
not debt. A

[[Page 23]]

modification of a debt instrument that results in an instrument or 
property right that is not debt for Federal income tax purposes is a 
significant modification. For purposes of this paragraph (e)(5)(i), any 
deterioration in the financial condition of the obligor between the 
issue date of the unmodified instrument and the date of modification (as 
it relates to the obligor's ability to repay the debt) is not taken into 
account unless, in connection with the modification, there is a 
substitution of a new obligor or the addition or deletion of a co-
obligor.
    (ii) Change in recourse nature--(A) In general. Except as provided 
in paragraph (e)(5)(ii)(B) of this section, a change in the nature of a 
debt instrument from recourse (or substantially all recourse) to 
nonrecourse (or substantially all nonrecourse) is a significant 
modification. Thus, for example, a legal defeasance of a debt instrument 
in which the issuer is released from all liability to make payments on 
the debt instrument (including an obligation to contribute additional 
securities to a trust if necessary to provide sufficient funds to meet 
all scheduled payments on the instrument) is a significant modification. 
Similarly, a change in the nature of the debt instrument from 
nonrecourse (or substantially all nonrecourse) to recourse (or 
substantially all recourse) is a significant modification. If an 
instrument is not substantially all recourse or not substantially all 
nonrecourse either before or after a modification, the significance of 
the modification is determined under paragraph (e)(1) of this section.
    (B) Exceptions--(1) Defeasance of tax-exempt bonds. A defeasance of 
a tax-exempt bond is not a significant modification even if the issuer 
is released from any liability to make payments under the instrument if 
the defeasance occurs by operation of the terms of the original bond and 
the issuer places in trust government securities or tax-exempt 
government bonds that are reasonably expected to provide interest and 
principal payments sufficient to satisfy the payment obligations under 
the bond.
    (2) Original collateral. A modification that changes a recourse debt 
instrument to a nonrecourse debt instrument is not a significant 
modification if the instrument continues to be secured only by the 
original collateral and the modification does not result in a change in 
payment expectations. For this purpose, if the original collateral is 
fungible or otherwise of a type where the particular units pledged are 
unimportant (for example, government securities or financial instruments 
of a particular type and rating), replacement of some or all units of 
the original collateral with other units of the same or similar type and 
aggregate value is not considered a change in the original collateral.
    (6) Accounting or financial covenants. A modification that adds, 
deletes, or alters customary accounting or financial covenants is not a 
significant modification.
    (f) Rules of application--(1) Testing for significance--(i) In 
general. Whether a modification of any term is a significant 
modification is determined under each applicable rule in paragraphs (e) 
(2) through (6) of this section and, if not specifically addressed in 
those rules, under the general rule in paragraph (e)(1) of this section. 
For example, a deferral of payments that changes the yield of a fixed 
rate debt instrument must be tested under both paragraphs (e) (2) and 
(3) of this section.
    (ii) Contingent modifications. If a modification described in 
paragraphs (e) (2) through (5) of this section is effective only upon 
the occurrence of a substantial contingency, whether or not the change 
is a significant modification is determined under paragraph (e)(1) of 
this section rather than under paragraphs (e) (2) through (5) of this 
section.
    (iii) Deferred modifications. If a modification described in 
paragraphs (e) (4) and (5) of this section is effective on a 
substantially deferred basis, whether or not the change is a significant 
modification is determined under paragraph (e)(1) of this section rather 
than under paragraphs (e) (4) and (5) of this section.
    (2) Modifications that are not significant. If a rule in paragraphs 
(e) (2) through (4) of this section prescribes a

[[Page 24]]

degree of change in a term of a debt instrument that is a significant 
modification, a change of the same type but of a lesser degree is not a 
significant modification under that rule. For example, a 20 basis point 
change in the yield of a fixed rate debt instrument is not a significant 
modification under paragraph (e)(2) of this section. Likewise, if a rule 
in paragraph (e)(4) of this section requires a change in payment 
expectations for a modification to be significant, a modification of the 
same type that does not result in a change in payment expectations is 
not a significant modification under that rule.
    (3) Cumulative effect of modifications. Two or more modifications of 
a debt instrument over any period of time constitute a significant 
modification if, had they been done as a single change, the change would 
have resulted in a significant modification under paragraph (e) of this 
section. Thus, for example, a series of changes in the maturity of a 
debt instrument constitutes a significant modification if, combined as a 
single change, the change would have resulted in a significant 
modification. The significant modification occurs at the time that the 
cumulative modification would be significant under paragraph (e) of this 
section. In testing for a change of yield under paragraph (e)(2) of this 
section, however, any prior modification occurring more than 5 years 
before the date of the modification being tested is disregarded.
    (4) Modifications of different terms. Modifications of different 
terms of a debt instrument, none of which separately would be a 
significant modification under paragraphs (e) (2) through (6) of this 
section, do not collectively constitute a significant modification. For 
example, a change in yield that is not a significant modification under 
paragraph (e)(2) of this section and a substitution of collateral that 
is not a significant modification under paragraph (e)(4)(iv) of this 
section do not together result in a significant modification. Although 
the significance of each modification is determined independently, in 
testing a particular modification it is assumed that all other 
simultaneous modifications have already occurred.
    (5) Definitions. For purposes of this section:
    (i) Issuer and obligor are used interchangeably and mean the issuer 
of a debt instrument or a successor obligor.
    (ii) Variable rate debt instrument and contingent payment debt 
instrument have the meanings given those terms in section 1275 and the 
regulations thereunder.
    (iii) Tax-exempt bond means a state or local bond that satisfies the 
requirements of section 103(a).
    (iv) Conduit loan and conduit borrower have the same meanings as in 
Sec. 1.150-1(b).
    (6) Certain rules for tax-exempt bonds--(i) Conduit loans. For 
purposes of this section, the obligor of a tax-exempt bond is the entity 
that actually issues the bond and not a conduit borrower of bond 
proceeds. In determining whether there is a significant modification of 
a tax-exempt bond, however, transactions between holders of the tax-
exempt bond and a borrower of a conduit loan may be an indirect 
modification under paragraph (a)(1) of this section. For example, a 
payment by the holder of a tax-exempt bond to a conduit borrower to 
waive a call right may result in an indirect modification of the tax-
exempt bond by changing the yield on that bond.
    (ii) Recourse nature--(A) In general. For purposes of this section, 
a tax-exempt bond that does not finance a conduit loan is a recourse 
debt instrument.
    (B) Proceeds used for conduit loans. For purposes of this section, a 
tax-exempt bond that finances a conduit loan is a recourse debt 
instrument unless both the bond and the conduit loan are nonrecourse 
instruments.
    (C) Government securities as collateral. Notwithstanding paragraphs 
(f)(6)(ii) (A) and (B) of this section, for purposes of this section a 
tax-exempt bond that is secured only by a trust holding government 
securities or tax-exempt government bonds that are reasonably expected 
to provide interest and principal payments sufficient to satisfy the 
payment obligations under the bond is a nonrecourse instrument.
    (g) Examples. The following examples illustrate the provisions of 
paragraphs (e) and (f) of this section:


[[Page 25]]


    Example 1. Modification of call right. (i) Under the terms of a 30-
year, fixed-rate bond, the issuer can call the bond for 102 percent of 
par at the end of ten years or for 101 percent of par at the end of 20 
years. At the end of the eighth year, the holder of the bond pays the 
issuer to waive the issuer's right to call the bond at the end of the 
tenth year. On the date of the modification, the issuer's credit rating 
is approximately the same as when the bond was issued, but market rates 
of interest have declined from that date.
    (ii) The holder's payment to the issuer changes the yield on the 
bond. Whether the change in yield is a significant modification depends 
on whether the yield on the modified bond varies from the yield on the 
original bond by more than the change in yield as described in paragraph 
(e)(2)(ii) of this section.
    (iii) If the change in yield is not a significant modification, the 
elimination of the issuer's call right must also be tested for 
significance. Because the specific rules of paragraphs (e)(2) through 
(e)(6) of this section do not address this modification, the 
significance of the modification must be determined under the general 
rule of paragraph (e)(1) of this section.
    Example 2. Extension of maturity and change in yield. (i) A zero-
coupon bond has an original maturity of ten years. At the end of the 
fifth year, the parties agree to extend the maturity for a period of two 
years without increasing the stated redemption price at maturity (i.e., 
there are no additional payments due between the original and extended 
maturity dates, and the amount due at the extended maturity date is 
equal to the amount due at the original maturity date).
    (ii) The deferral of the scheduled payment at maturity is tested 
under paragraph (e)(3) of this section. The safe-harbor period under 
paragraph (e)(3)(ii) of this section starts with the date the payment 
that is being deferred is due. For this modification, the safe-harbor 
period starts on the original maturity date, and ends five years from 
this date. All payments deferred within this period are unconditionally 
payable before the end of the safe-harbor period. Thus, the deferral of 
the payment at maturity for a period of two years is not a material 
deferral under the safe-harbor rule of paragraph (e)(3)(ii) of this 
section and thus is not a significant modification.
    (iii) Even though the extension of maturity is not a significant 
modification under paragraph (e)(3)(ii) of this section, the 
modification also decreases the yield of the bond. The change in yield 
must be tested under paragraph (e)(2) of this section.
    Example 3. Change in yield resulting from reduction of principal. 
(i) A debt instrument issued at par has an original maturity of ten 
years and provides for the payment of $100,000 at maturity with interest 
payments at the rate of 10 percent payable at the end of each year. At 
the end of the fifth year, and after the annual payment of interest, the 
issuer and holder agree to reduce the amount payable at maturity to 
$80,000. The annual interest rate remains at 10 percent but is payable 
on the reduced principal.
    (ii) In applying the change in yield rule of paragraph (e)(2) of 
this section, the yield of the instrument after the modification 
(measured from the date that the parties agree to the modification to 
its final maturity date) is computed using the adjusted issue price of 
$100,000. With four annual payments of $8,000, and a payment of $88,000 
at maturity, the yield on the instrument after the modification for 
purposes of determining if there has been a significant modification 
under paragraph (e)(2)(i) of this section is 4.332 percent. Thus, the 
reduction in principal is a significant modification.
    Example 4. Deferral of scheduled interest payments. (i) A 20-year 
debt instrument issued at par provides for the payment of $100,000 at 
maturity with annual interest payments at the rate of 10 percent. At the 
beginning of the eleventh year, the issuer and holder agree to defer all 
remaining interest payments until maturity with compounding. The yield 
of the modified instrument remains at 10 percent.
    (ii) The safe-harbor period of paragraph (e)(3)(ii) of this section 
begins at the end of the eleventh year, when the interest payment for 
that year is deferred, and ends at the end of the sixteenth year. 
However, the payments deferred during this period are not 
unconditionally payable by the end of that 5-year period. Thus, the 
deferral of the interest payments is not within the safe-harbor period.
    (iii) This modification materially defers the payments due under the 
instrument and is a significant modification under paragraph (e)(3)(i) 
of this section.
    Example 5. Assumption of mortgage with increase in interest rate. 
(i) A recourse debt instrument with a 9 percent annual yield is secured 
by an office building. Under the terms of the instrument, a purchaser of 
the building may assume the debt and be substituted for the original 
obligor if the purchaser has a specified credit rating and if the 
interest rate on the instrument is increased by one-half percent (50 
basis points). The building is sold, the purchaser assumes the debt, and 
the interest rate increases by 50 basis points.
    (ii) If the purchaser's acquisition of the building does not satisfy 
the requirements of paragraphs (e)(4)(i) (B) or (C) of this section, the 
substitution of the purchaser as the obligor is a significant 
modification under paragraph (e)(4)(i)(A) of this section.
    (iii) If the purchaser acquires substantially all of the assets of 
the original obligor, the assumption of the debt instrument will not 
result in a significant modification if there is not a change in payment 
expectations and

[[Page 26]]

the assumption does not result in a significant alteration.
    (iv) The change in the interest rate, if tested under the rules of 
paragraph (e)(2) of this section, would result in a significant 
modification. The change in interest rate that results from the 
transaction is a significant alteration. Thus, the transaction does not 
meet the requirements of paragraph (e)(4)(i)(C) of this section and is a 
significant modification under paragraph (e)(4)(i)(A) of this section.
    Example 6. Assumption of mortgage. (i) A recourse debt instrument is 
secured by a building. In connection with the sale of the building, the 
purchaser of the building assumes the debt and is substituted as the new 
obligor on the debt instrument. The purchaser does not acquire 
substantially all of the assets of the original obligor.
    (ii) The transaction does not satisfy any of the exceptions set 
forth in paragraph (e)(4)(i) (B) or (C) of this section. Thus, the 
substitution of the purchaser as the obligor is a significant 
modification under paragraph (e)(4)(i)(A) of this section.
    (iii) Section 1274(c)(4), however, provides that if a debt 
instrument is assumed in connection with the sale or exchange of 
property, the assumption is not taken into account in determining if 
section 1274 applies to the debt instrument unless the terms and 
conditions of the debt instrument are modified in connection with the 
sale or exchange. Because the purchaser assumed the debt instrument in 
connection with the sale of property and the debt instrument was not 
otherwise modified, the debt instrument is not retested to determine 
whether it provides for adequate stated interest.
    Example 7. Substitution of a new obligor in section 381(a) 
transaction. (i) The interest rate on a 30-year debt instrument issued 
by a corporation provides for a variable rate of interest that is reset 
annually on June 1st based on an objective index.
    (ii) In the tenth year, the issuer merges (in a transaction to which 
section 381(a) applies) into another corporation that becomes the new 
obligor on the debt instrument. The merger occurs on June 1st, at which 
time the interest rate is also reset by operation of the terms of the 
instrument. The new interest rate varies from the previous interest rate 
by more than the greater of 25 basis points and 5 percent of the annual 
yield of the unmodified instrument. The substitution of a new obligor 
does not result in a change in payment expectations.
    (iii) The substitution of the new obligor occurs in a section 381(a) 
transaction and does not result in a change in payment expectations. 
Although the interest rate changed by more than the greater of 25 basis 
points and 5 percent of the annual yield of the unmodified instrument, 
this alteration did not occur as a result of the transaction and is not 
a significant alteration under paragraph (e)(4)(i)(E) of this section. 
Thus, the substitution meets the requirements of paragraph (e)(4)(i)(B) 
of this section and is not a significant modification.
    Example 8. Substitution of credit enhancement contract. (i) Under 
the terms of a recourse debt instrument, the issuer's obligations are 
secured by a letter of credit from a specified bank. The debt instrument 
does not contain any provision allowing a substitution of a letter of 
credit from a different bank. The specified bank, however, encounters 
financial difficulty and rating agencies lower its credit rating. The 
issuer and holder agree that the issuer will substitute a letter of 
credit from another bank with a higher credit rating.
    (ii) Under paragraph (e)(4)(iv)(A) of this section, the substitution 
of a different credit enhancement contract is not a significant 
modification of a recourse debt instrument unless the substitution 
results in a change in payment expectations. While the substitution of a 
new letter of credit by a bank with a higher credit rating does not 
itself result in a change in payment expectations, such a substitution 
may result in a change in payment expectations under certain 
circumstances (for example, if the obligor's capacity to meet payment 
obligations is dependent on the letter of credit and the substitution 
substantially enhances that capacity from primarily speculative to 
adequate).
    Example 9. Improvement to collateral securing nonrecourse debt. A 
parcel of land and its improvements, a shopping center, secure a 
nonrecourse debt instrument. The obligor expands the shopping center 
with the construction of an additional building on the same parcel of 
land. After the construction, the improvements that secure the 
nonrecourse debt include the new building. The building is an 
improvement to the property securing the nonrecourse debt instrument and 
its inclusion in the collateral securing the debt is not a significant 
modification under paragraph (e)(4)(iv)(B) of this section.

    (h) Effective date. This section applies to alterations of the terms 
of a debt instrument on or after September 24, 1996. Taxpayers, however, 
may rely on this section for alterations of the terms of a debt 
instrument after December 2, 1992, and before September 24, 1996.

[T.D. 8675, 61 FR 32930, June 26, 1996; 61 FR 47822, Sept. 11, 1996]