Whether an automatic interest rate change, in a debt instrument, results in a taxable event, due to a change in the federal corporate tax rate
This addresses, within the context of federal tax law, whether there is a “modification of a debt instrument” when the interest rate on a bond automatically changes due to a change in the federal corporate tax rate (as has recently occurred).
This question came up in actual tax practice due to the lowering of the corporate tax rate in the 2017 Tax Cuts and Jobs Act (the “Act”).
Some bonds, or other debt instruments, per their terms, adjust the bond’s interest rate in the case of a change in the federal corporate tax rate. This occurs automatically in many cases and does not depend on the unilateral action of any party, whether it is the issuer of the bond or the bondholder.
The rules of “modification”, “significant modification”, and “unilateral change”, causing a possible taxable event with regard to a debt instrument, all find their origin in Section 1.1001-3 of the federal income tax regulations (the “Regulations”).
Where the change in interest rate of a bond is automatic upon the happening of an event, which is based on “objective financial information”, the change is not unilateral by any party, and is not, therefore, a modification of the debt instrument.
While it is rare to find a ruling or example in tax literature with regard to automatic changes to a bond’s interest rate, due to a change in the federal corporate tax rate, an example set forth below as to “reset bonds” shows that an automatic reset is not a modification of the terms of the bond.
Therefore, there is no taxable transaction that would be based on a modification which is a significant modification for purposes of the Regulations, where the change is automatic and not unilateral. What is referred to as a “modification”, for tax purposes, may sometimes be referred to in the bond finance world as a “reissuance”.
The rules in this area all originate in Regulations, in a section entitled Modifications of Debt Instruments. (Section 1.1001-3).
For tax purposes, the rules are concerned with whether there is a taxable “exchange”; to wit, a possible taxable gain due to one particular asset, with a given value, being exchanged for another asset of a different value.
The rules can apply to any modification of a debt instrument, regardless of the form of the modification. This can happen with an exchange of a new instrument for an existing debt instrument, or to an amendment of an existing debt instrument. [1.1001-3(a) 1)].
If there is a significant modification, the possibility exists that a transaction has occurred where the value of what is received has to be measured against the value that is given up, with
consequences. A rule often encountered, for example, as to a 25 basis point increase, resulting in a “significant modification”, is found in these Regulations.
However, the significant modification rules do not have to be addressed if there is no modification of the debt instrument.
Normally, an alteration of a legal right that occurs by operation of the terms of the debt instrument is not a modification. An alteration that occurs by operation of the terms may occur, automatically, such as the annual resetting of the interest rate based on the value of an index. (1.1001-3(c)(1)(ii)]. See Example # 1 discussed below.
There are exceptions set forth in Regulation Section 1.1001-3(c)(2), which lists “alterations” that are “modifications”, even if the alterations occur by operation of the terms of the debt instrument.
Among the exceptions is a “unilateral option”. [1.1001-3(c)(3)]. Under paragraph (3) an option to alter a debt instrument is “unilateral” if:
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
o a person who is related to the issuer (under various Internal Revenue Code relationship tests);
The exercise of the option does not require the consent or approval of —
- a. The other party; A person who is related to that party, whether or not that person is a party to
the instrument; or C. The exercise of the option does not require consideration, other than a de
minimis amount, or an amount that is based on a formula that uses objective financial information (as defined in a separate section of the Regulations discussed immediately below).
The Regulations provide that “objective financial information” is any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract and is not unique to one of the parties circumstances (such as dividends or profits). [1.446-4(ii)].
No ruling applies these regulations directly to a change in the federal corporate tax rate — generating an automatic change in the bond’s interest rate.
However, Example # (1) in Regulation Section 1.1001-3(d) would seem to provide that a change in interest rate, due to the existing terms of a bond, is not a unilateral action and, therefore, not a modification.
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 (as described in the Regulations). Thus, the reset of the interest rate is not a significant, taxable, modification of the debt instrument.
The conclusion is different where one party has an option of make a change. Per Example (9) of the same paragraph in the Regulations, 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 if certain covenants in the note are breached. The bank’s right to increase the interest rate is a unilateral option, and, therefore, is a modification.
The issue of a unilateral option, if unexercised, is discussed in Regulation Section 1.1001(c)(5), as follows:
“(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”.
In the above-described matter, which I reviewed in actual law practice, since the adjustment of the interest rate in a 2012 bank purchase bond, due to the downward change in the federal corporate tax rate under the 2017 Tax Act, was an automatic occurrence, and not a unilateral option of any party (which could be exercised or not exercised), the analysis illustrated that there was no modification of the debt instrument which would call into question its taxability for federal tax purposes.