I. Introduction

On September 12, 2012, the Internal Revenue Service (the "IRS") issued Final Treasury Regulations (the "Final Regulations") that clarify the circumstances that cause property to be treated as "traded on an established market" for purposes of determining the issue price of a debt instrument that is issued for property. The Final Regulations broadly define the term "traded on an established market." These new rules could create adverse U.S. federal income tax issues for borrowers and certain lenders in connection with certain restructurings, recapitalizations, debt-for-debt exchanges and amendments or modifications to credit agreements and other debt instruments. In particular, these new rules could create adverse results in the case of distressed borrowers. If a debt instrument is traded on an established market, the fair market value of such debt instrument (rather than its stated redemption price at maturity), generally must be used to determine whether cancellation of indebtedness income ("COD income") of the borrower, or any "original issue discount" ("OID") with respect to the debt instrument, results from a significant modification of the debt instrument for U.S. federal income tax purposes. While the preamble to these new rules indicates that "potential distortions created by distressed debt obligations are the subject of a separate guidance project," no additional guidance has been issued yet to address these distortions. The Final Regulations also amend the current regulations addressing potentially abusive situations and reopenings of debt instruments. Other than with respect to reopenings, the Final Regulations do not change the rules that are applicable for determining the issue price of debt instruments that are issued for cash.

II. Definition of Traded on an Established Market

A. Background

In general, for U.S. federal income tax purposes, the issue price of a debt instrument that is issued for property is its fair market value if the debt instrument is (i) traded on an established market or (ii) issued for property that is traded on an established market. The issue price of any other debt instrument that is issued for property generally is its stated redemption price at maturity (i.e., very generally, its principal amount) if the debt instrument provides for adequate stated interest. Under the Treasury Regulations that will be replaced by the Final Regulations (the "Prior Regulations"), property is treated as traded on an established market if the property:

• is listed on a specified exchange or quotation system;
• is of a kind that is traded on a board of trade designated as a contract market by the Commodities Futures Trading Commission or on an interbank market;
• appears on a system of general circulation that disseminates recent price quotations or actual prices of recent sales transactions ("a quotation medium"), or
• is a debt instrument for which price quotations are readily available from dealers, brokers or traders, subject to certain safe harbors ("readily quotable debt instruments").

On January 7, 2011, the IRS issued Proposed Treasury Regulations (the "Proposed Regulations") amending the foregoing rules. The most significant change in the Proposed Regulations (and by far the most controversial) is a provision that treats debt as traded on an established market if an "indicative quote" is available. The Final Regulations substantially follow the framework established in the Proposed Regulations, but in response to comments, include several changes.

B. The Final Regulations

Under the Final Regulations, property is treated as traded on an established market if, at any time during the 31 day period ending 15 days after the issue date of the debt instrument:

• there is a sales price for the property;
• there are one or more firm quotes for the property; or
• there are one or more indicative quotes for the property.

If any of the foregoing criteria is met, the fair market value of the property is presumed to be the sales price or quoted price that is available. For purposes of the foregoing:

• A sales price exists for property if the price for an executed purchase or sale of the property is reasonably available within a reasonable period of time after the sale. For this purpose, the price of a debt instrument is considered reasonably available if the sales price (or information sufficient to calculate the sales price) appears in a medium that is made available to issuers of debt instruments, persons that regularly purchase or sell debt instruments (including a price provided only to certain customers or to subscribers), or persons that broker purchases or sales of debt instruments.
• A firm quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) for property and the quoted price is substantially the same as the price for which the person receiving the quoted price could purchase or sell the property. A price quote is considered to be available whether the quote is initiated by the person providing the quote or provided at the request of the person receiving the quote. The identity of the person providing the quote must be reasonably ascertainable. A quote will be considered a firm quote if the quote is designated as a firm quote by the person providing the quote or if market participants typically purchase or sell, as the case may be, at the quoted price, even if the party providing the quote is not legally obligated to purchase or sell at that price.
• An indicative quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers).
• Taxpayers are permitted to use any reasonable method, consistently applied to the same or substantially similar facts, to determine fair market value when there is more than one sales price or price quote. The Final Regulations provide a nonexclusive list of factors a taxpayer may consider to establish fair market value, including: (a) the timing of each relevant sale or quote in relation to the issue date; (b) whether the price is derived from a sale, a firm quote, or an indicative quote; (c) the size of each relevant sale or quote; or (d) whether the sales price or quote corresponds to pricing information provided by an independent bond or loan pricing service. In response to comments, the Final Regulations add an anti-abuse rule that disregards any sales or price quote that has a principal purpose of (i) causing the property to be traded on an established market or (ii) materially misrepresenting the value of property for income tax purposes.

The Final Regulations provide an exception to the foregoing rules for small debt issues (the "Small Issue Exception"). For this purpose, a debt instrument will not be treated as traded on an established market if the outstanding stated principal amount of the issue that includes the debt instrument does not exceed $100 million at the time the determination is made. The Final Regulations expand this exception to $100 million from the $50 million exception provided in Proposed Regulations. In this regard, the Prior Regulations include a limited exception to the definition of "readily quotable debt instruments" for debt issues with original stated principal amounts of $25 million or less.

The Final Regulations require that the issue price of a debt instrument be reported consistently by issuers and holders. For this purpose, an issuer’s determination of whether property is traded on an established market and, if it is, the property’s fair market value generally is binding on the holders of the debt instrument. If the issuer determines that property is traded on an established market, the Final Regulations require the issuer of a debt instrument to make that determination and the fair market value of the property available to holders in a commercially reasonable fashion, including by electronic publication within 90 days of the date that the debt instrument is issued. The determination by the issuer is binding on a holder of the debt instrument unless the holder explicitly discloses that its determination is different from the issuer’s determination. A holder must describe in the disclosure the reasons for its different determination and, if applicable, how the holder determined fair market value. A holder’s disclosure must be filed on a timely filed U.S. federal income tax return. The requirement that issuers provide information to holders regarding their determinations of whether debt instruments are traded on an established market and the fair market value of property does not exclude foreign issuers of debt instruments. However, the Final Regulations do not provide for a penalty if the issuer of a debt instrument fails to provide the required information to holders.

The rules described in this section apply to debt instruments issued on or after November 13, 2012.

C. Analysis

As noted above, the Final Regulations expand the conditions under which a debt instrument will be considered to be traded on an established market. For example, the Final Regulations treat a debt instrument as traded on an established securities market if a single indicative price quote is available for the debt instrument or related property. Therefore, the issue price of a debt instrument that is issued for property is more likely to be its fair market value. This change will be particularly relevant in the case of debt-for-debt exchanges and restructurings of existing debt instruments that give rise to deemed reissuances for U.S. federal income tax purposes. In the case of a debt-for-debt exchange or a transaction that gives rise to a deemed reissuance of a debt instrument, if neither the original/unmodified debt instrument nor the new/modified debt instrument is traded on an established market, the issue price of the new/modified debt instrument generally will be its stated redemption price at maturity. Accordingly, such a debt-for-debt exchange/deemed reissuance often will not result in the (i) recognition of COD income by the issuer of the debt instrument, (ii) recognition of gain or loss by the holder of the debt instrument, or (iii) the new/modified debt instrument being treated as issued with OID. However, if the original/unmodified debt instrument or the new/modified debt instrument is traded on an established market, the issue price of the new/modified debt instrument generally will be the fair market value of the original/unmodified debt instrument or the new/modified debt instrument, as the case may be. This treatment can result in the (i) recognition of COD income by the issuer of the debt instrument, (ii) recognition of gain or loss by the holder of the debt instrument, and (iii) the new/modified debt instrument being treated as issued with OID. The following example illustrates these consequences.

Example

Pursuant to a credit agreement dated January 1, 2011, Bank C loans $200 million to Corporation A. The credit agreement provides for a fixed rate of interest of 5%. The $200 million principal amount of the loan is payable on January 1, 2015. On January 30, 2011, Corporation B, an insurance company that invests in commercial loans for its own account, purchases the loan from Bank C for $200 million. On October 1, 2012, Corporation A informs Corporation B that it does not expect to be able to repay the principal amount of the loan on the scheduled maturity date. Corporation B tentatively agrees to certain modifications to the credit agreement in order to enable Corporation A to repay the loan. The modifications include an extension of the maturity date of the loan until January 1, 2018. In connection with the amendment of the credit agreement, on December 30, 2012, Corporation B requests a nonbinding quote of the value of the loan from Bank C. The quote provided by Bank C values the loan at $150 million. Neither causing the loan to be traded on an established market, nor materially misrepresenting the value of the loan, is a principal purpose for the existence of the quote provided by Bank C. On January 1, 2013, the credit agreement is amended to reflect these modifications. Corporation B does not mark the loan to market for U.S. federal income tax purposes and at the time of the modification, its U.S. federal income tax basis in the loan is $200 million. All interest on the loan is qualified stated interest for U.S. federal income tax purposes. Corporation A is neither in bankruptcy nor insolvent for U.S. federal income tax purposes at the time of the modification. Corporation B holds the loan as a capital asset. The extension of the maturity date of the loan does not constitute a tax-free recapitalization under Section 368 (a)(1)(E) of the U.S. Internal Revenue Code of 1986, as amended (the "Code").

For U.S. federal income tax purposes, as a result of the modifications agreed to on January 1, 2013, Corporation A generally will be treated as having issued a new modified loan in satisfaction of its obligations under the original loan. Under the rules described above, for U.S. federal income tax purposes:

• the original loan is treated as property that is traded on an established market;
• the fair market value of the original loan is $150 million (i.e., the value quoted by Bank C on December 30, 2012);
• the issue price of the new modified loan is $150 million;
• the new modified loan is issued with $50 million of OID (i.e., the difference between its $150 million issue price and its $200 million stated redemption price at maturity) which generally will be taken into account by Corporation A (as interest deductions) and Corporation B (as interest income) over the term of the new modified loan under the U.S. federal income tax rules applicable to OID;
• Corporation A recognizes COD income of $50 million (i.e., the difference between the $200 million owed on the original loan and the $150 million fair market value of the new modified loan issued in satisfaction of the original loan); and
• Corporation B recognizes a $50 million capital loss on the deemed exchange of the original loan for the new modified loan.

III. Rules Regarding Potentially Abusive Situations Modified to Exclude Debt-for-Debt Exchanges

Section 1274 of the Code addresses the treatment of debt instruments issued in exchange for property. It contains an anti-abuse rule that prevents the issue price of a debt instrument from being overstated. Under this rule, in certain potentially abusive situations, the issue price of a debt instrument issued in exchange for property is the fair market value of such property, rather than the debt instrument’s stated principal amount or imputed principal amount (as determined under Section 1274(b) of the Code). One such potentially abusive situation is where there has been a recent sale of property (a "recent sales transaction"). Under the Final Regulations, a debt instrument issued in a debt-for-debt exchange, including a deemed exchange, is not treated as the subject of a recent sales transaction for purposes of Section 1274(b)(3)(B)(ii)(I) of the Code, even if the debt instrument exchanged for the new/modified debt instrument has been recently acquired before the exchange. Accordingly, the issue price of the new/modified debt instrument will not be equal to the fair market value of the original debt instrument under this rule. However, unless the Small Issue Exception applies, if the new/modified debt instrument or the original debt instrument is traded on an established market, the issue price of the new/modified debt instrument generally will be the fair market value of such debt instrument or the original debt instrument, as the case may be. The foregoing rules apply to debt instruments issued on or after November 13, 2012.

IV. Reopenings of Debt Instruments

Debt instruments that are issued as part of a "qualified reopening" generally are treated as part of the same issue as an original issue of debt instruments for U.S. federal income tax purposes. Prior to the issuance of the Final Regulations, qualified reopenings were limited to reopenings where the original debt instruments were traded on an established market. Therefore, unlike in the case of a debt-for-debt exchange of distressed debt where the treatment of debt as traded on an established market may be unfavorable to a borrower since a depressed fair market value may result in COD income, generally, it was more favorable under the prior qualified reopening rules for original debt instruments to be traded on an established market.

The Final Regulations expand the definition of qualified reopening. Under the Final Regulations, a debt instrument may be issued as part of a qualified reopening even if the original debt instrument is not traded on an established market, if the new debt instrument is issued within six months of the issue date of the original debt instruments for cash to persons unrelated to the issuer for an arm’s length price and rules similar to the rules that apply to debt instruments that are traded on an established market are met. Additionally, under the Final Regulations, debt instruments may be issued in a qualified reopening more than six months after the issue date of the original debt instruments if (x) either the original debt instruments are traded on an established market or the original debt instruments are non-publicly traded and are issued for cash to unrelated persons for an arm’s length price and (y), on the date on which the price of the additional debt instruments is established (or, if earlier, the announcement date), the yield of the additional debt instruments is not more than 100% of the yield of the original debt instruments on their issue date. Thus, under the Final Regulations, the treatment of an original debt instrument as traded on an established market is less important. Unlike the other sections of the Final Regulations that are described in this alert, the foregoing rules generally apply to debt instruments that are part of a reopening if the reopening date is on or after September 13, 2012. Thus, the Final Regulations will apply to reopenings even where the original debt instrument was issued prior to September 13, 2012.

V. Summary

The Final Regulations will impact taxpayers differently, depending on whether they are issuers or borrowers.

• Definition of Traded on an Established Market – In general, under the Final Regulations property is more likely to be treated as traded on an established market. This change will be particularly relevant in the case of debt-for-debt exchanges and restructurings of existing debt instruments, potentially causing adverse results for distressed borrowers and certain lenders.
• Exclusion of Debt-for-Debt Exchanges from the Rules Applicable to Potentially Abusive Situations – Under the Final Regulations debt instruments issued in debt-for-debt exchanges (including deemed exchanges) are not subject to the rules applicable to recent sales transactions that require the use of fair market value for purposes of determining issue price. However, this exemption may have limited applicability where the Small Issue Exception does not apply, since it is more likely that debt instruments will be treated as traded on established markets under the Final Regulations (i.e., it is likely that the issue price of debt instruments issued for property will be determined by reference to fair market value). Thus, the impact of this provision may be limited.
• Reopenings of Debt Instruments – The Final Regulations liberalize the rules applicable to reopenings of debt instruments. Under the Final Regulations, (i) debt instruments may be issued in a qualified reopening more than six months after the issue date of the original debt instruments, and (ii) qualified reopenings of debt instruments that are not traded on an established market are permitted, in each case, if certain conditions are met.

Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, please note that any tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding tax-related penalties that may be imposed on the taxpayer.