SERVICE ISSUES REVENUE RULING ON U.S. BANK'S TREATMENT OF DEBT REDUCTION GRANTED TO FOREIGN GOVERNMENT.

Rev. Rul. 89-122

ISSUES

(1) In the transactions described below, which are part of a foreign country's program to reduce the amount of its outstanding debt to United States commercial banks, what is the amount of gain or loss, if any, realized and recognized by the commercial banks?

(2) What is the carryback and carryover treatment of the portion of a commercial bank's net operating loss that is attributable to a loss recognized from these transactions?

FACTS

X, a United States commercial bank, holds a United States dollar denominated sovereign debt (the "Obligation") of foreign country FC. The Obligation evidences a loan from X to FC in the principal amount of $1,000,000 and bears interest at a rate of 10 percent per annum, payable annually. At the time of the transactions described below, X's adjusted basis in the Obligation, under section 1011 of the Internal Revenue Code, is $1,000,000. The Obligation is property that is not publicly traded within the meaning of section 1273(b)(B) of the Code. X files its tax returns on a calendar year basis, uses the accrual method of accounting, and uses the specific charge-off method of accounting for bad debts. X did not make the election described in section 585(c)(4) concerning the elective cut-off method of changing from the reserve method of accounting for bad debts.

To reduce the amount of United States dollar denominated sovereign debt owed by FC, FC has adopted a program (the "Program") under which a holder of this debt may negotiate with FC to modify the terms of the debt. In accordance with the Program, X and FC modify the Obligation during 1989 in the manner described in either of the following situations:

Situation 1

FC and X agree to reduce the rate of interest on the Obligation to 6.25 percent per annum, payable annually. The principal amount of the modified Obligation remains at $1,000,000. The present value of the payments on the modified Obligation, computed using a discount rate equal to the applicable Federal rate on the date of the modification, compounded semi-annually, is less than $1,000,000. Thus, the modified Obligation does not bear adequate stated interest within the meaning of section 1274(c)(2) of the Code. The modified Obligation is not publicly traded within the meaning of section 1273(b)(3).

Situation 2

FC and X agree to reduce the principal amount of the Obligation to $650,000. The interest rate remains at 10 percent per annum, payable annually. The present value of the payments on the modified Obligation, computed using a discount rate equal to the applicable Federal rate on the date of the modification, compounded semi- annually, is greater than $650,000. Thus, the modified Obligation bears adequate stated interest within the meaning of section 1274(c)(2) of the Code. The modified Obligation is not publicly traded within the meaning of section 1273(b)(3).

LAW AND ANALYSIS

In Situations 1 and 2 the terms of the Obligation are modified. Under section 1001 of the Code, if property is exchanged for other property that differs materially either in kind or in extent, then gain or loss usually results from the exchange. See section 1.1001- 1(a) of the Income Tax Regulations. In general, the modification of a debt instrument constitutes a deemed exchange of debt instruments under section 1001 if the modified debt instrument is materially different from the original debt instrument. If the modification constitutes a deemed exchange, then the resulting modified instrument is treated as a newly issued debt instrument for federal income tax purposes.

In Rev. Rul. 81-169, 1981-1 C.B. 429, a taxpayer owned a municipal bond bearing interest at 9 percent, maturing February 1, 1996, and subject to sinking fund payments calculated to provide for level debt service. The taxpayer exchanged that bond for a bond of equal face amount bearing interest at 8 1/2 percent, maturing February 1, 2006, and not subject to a sinking fund provision. The revenue ruling concludes that the changes in the terms of the bonds, taken together, were material. Therefore, the exchange was a taxable transaction under section 1001 of the Code.

In Rev. Rul. 87-19, 1987-1 C.B. 249, a taxpayer owned municipal bonds bearing interest at 7 percent that contained an interest adjustment clause that triggered an increase in the interest rate on the bonds in the event of a decrease in the maximum marginal federal corporation income tax rate. Prior to the date the increase would have been triggered, the bondholder waived its rights under the interest adjustment clause. Thus, the bonds continued to bear a 7 percent interest rate rather than the 8.56 percent interest rate that would have resulted under the interest adjustment clause. The ruling concludes that the waiver was a material change in the terms of the bonds, resulting in a deemed issuance of new bonds and a taxable exchange under section 1001 of the Code.

In Situation 1, the change in interest rate from 10 percent to 6.25 percent represents a material change in the terms of the Obligation. In Situation 2, the reduction in the stated principal amount of the Obligation from $1,000,000 to $650,000 represents a material change in the terms of the Obligation. Therefore, in each situation, the modification results in a deemed exchange of the original Obligation for the modified Obligation under section 1001 of the Code.

Because the modification in each situation results in a deemed exchange, X may realize and recognize a gain or loss on each exchange. See Emery v. Commissioner, 166 F.2d 27 (2d Cir. 1948), aff'g 8 T.C. 979 (1947) (exchange of bonds of municipal corporation does not constitute a tax-free recapitalization). Under section 1001 of the Code, the gain or loss from an exchange of property is determined by reference to the amount realized by the taxpayer from the exchange and the taxpayer's adjusted basis in the property as determined under section 1011. Section 1001(b) provides that the amount realized is the sum of any money received plus the fair market value of the property (other than money) received.

Rev. Rul. 79-292, 1979-2 C.B. 287, deals with the determination of the amount realized under section 1001(b) of the Code by a taxpayer that uses the accrual method of accounting. In Rev. Rul. 79- 292, the taxpayer received long-term obligations on two separate sales of property. Based on an analysis of the accrual method of accounting under section 451 and the regulations thereunder, Rev. Rul. 79-292 indicates that the unconditional right to receive money by an accrual basis taxpayer is treated as money received to the full extent of the face value of the right rather than as property received. Therefore, Rev. Rul. 79-292 concludes that the amount realized by the taxpayer on each sale is the sum of the face amount of the notes plus the amount of any cash received. In reaching this conclusion, Rev. Rul. 79-292 indicates that the fair market value of a note received by an accrual basis taxpayer is irrelevant in determining the amount realized from the sale or other disposition of property.

Although Rev. Rul. 79-292 concludes that the amount realized by a taxpayer that uses the accrual method of accounting includes the face amount of a note, this amount does not include any amount that is, in effect, recharacterized as interest under section 1274 of the Code. In general, section 1274 determines the issue price of a debt instrument issued in consideration for the sale or exchange of nonpublicly traded property. The issue price of such a note is the portion of the face amount that is not recharacterized as interest under section 1274.

Under section 1274 of the Code, if a debt instrument has adequate stated interest, then the issue price of the debt instrument generally is the stated principal amount (i.e., face amount) of the instrument. See section 1274(a)(1). Under section 1274(c)(2), a debt instrument generally has adequate stated interest for purposes of section 1274 if the stated principal amount of the debt instrument is less than or equal to the imputed principal amount of the debt instrument, determined under section 1274(b). Under section 1274(b), the imputed principal amount of the debt instrument generally is the sum of the present values of all payments due under the instrument, determined by using a discount rate equal to the applicable Federal rate, compounded semi-annually.

If the interest rate is inadequate, however, then the issue price of the debt instrument generally is the imputed principal amount of the instrument. See section 1274(a)(2) of the Code. The difference between the stated principal amount of the instrument and the imputed principal amount is treated as unstated interest that is accounted for under the original issue discount provisions of the Code.

In Situations 1 and 2, the modification of the Obligation results in a deemed exchange under section 1001 of the Code, and, therefore, the modified Obligation is treated as a newly issued debt instrument for federal income tax purposes. Because the modified Obligation in each situation is issued for nonpublicly traded property (the original Obligation), section 1274 generally determines the issue price of the modified Obligation.

In Situation 1, because the modified Obligation does not have adequate stated interest, the issue price of the modified Obligation under section 1274 of the Code is the imputed principal amount. As a result, X realizes and recognizes a loss upon the deemed exchange equal to the difference between X's adjusted basis in the original Obligation and the imputed principal amount of the modified Obligation.

In Situation 2, however, the modified Obligation has adequate stated interest. As a result, X realizes and recognizes a loss upon the deemed exchange equal to the difference between X's adjusted basis in the original Obligation and the stated principal amount of the modified Obligation.

Section 172(b)(1)(A) of the Code provides that a net operating loss (NOL) for any taxable year generally may be carried back to the 3 taxable years preceding the taxable year of the loss. Section 172(b)(1)(B) provides that an NOL for any taxable year generally may be carried forward to the 15 taxable years following the taxable year of the loss. In the case of a bank (as defined in section 585(a)(2)), however, section 172(b)(1)(K) provides that the portion of the NOL for any taxable year beginning after December 31, 1986, and before January 1, 1994, that is attributable to the deduction allowed under section 166(a) (relating to bad debts) may be carried back to the 10 taxable years preceding the taxable year of the loss, but may be carried forward only to the 5 taxable years following the taxable year of the loss.

Each exchange is the result of a bilateral agreement between X and FC, pursuant to which FC's obligation is modified, rather than a unilateral determination by X that a portion of the debt has been rendered uncollectible. Therefore, in Situations 1 and 2, the loss recognized is a loss that results from the exchange of property. The amount of the loss is determined under section 1001 of the Code and is allowed as a loss deduction to X pursuant to section 165, rather than section 166. Thus, section 172(b)(1)(K) does not apply to the loss recognized by X in either Situation 1 or Situation 2. Accordingly, the loss recognized in either Situation 1 or Situation 2 that is part of X's NOL, if any, for the taxable year may be carried back to the 3 taxable years preceding the taxable year of the loss and may be carried forward to the 15 taxable years following the taxable year of the loss.

HOLDINGS

Situation 1

The reduction in the interest rate of the Obligation is a material modification that results in a taxable exchange of debt instruments under section 1001 of the Code. X realizes and recognizes a loss on the exchange equal to the excess of X's adjusted basis in the original Obligation over the imputed principal amount of the modified Obligation as determined under section 1274. The portion of X's net operating loss, if any, for the taxable year that is attributable to this loss may be carried back 3 years and forward 15 years.

Situation 2

The reduction in stated principal amount of the Obligation is a material modification that results in a taxable exchange of debt instruments under section 1001 of the Code. X realizes and recognizes a loss on the exchange equal to the excess of X's adjusted basis in the original Obligation over the stated principal amount of the modified Obligation. The portion of X's net operating loss, if any, for the taxable year that is attributable to this loss may be carried back 3 years and forward 15 years.

EFFECT ON OTHER REVENUE RULINGS

Prior to the Tax Reform Act of 1984, former section 483 of the Code generally determined the principal and interest elements of a debt instrument issued upon the sale or exchange of property. In Rev. Rul. 79-292, the interest rate on the notes satisfied the test rate under former section 483 and the regulations. Therefore, no portion of the face amount of the notes was recharacterized as interest under former section 483. Rev. Rul. 79-292 is clarified by removing any implication created by that ruling that the amount realized includes unstated interest.

DRAFTING INFORMATION

The principal author of this revenue ruling is William E. Blanchard of the Office of the Assistant Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling contact Mr. Blanchard on (202) 566-3142 (not a toll- free call).