||January 28, 1998
Modifications of Bad Debts & Dealer Assignments
of Notional Principal Contracts
DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8763] RIN 1545-AU06
TITLE: Modifications of Bad Debts and Dealer Assignments of Notional
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final and temporary regulations.
SUMMARY: This document contains regulations that deem a charge-off
and allow a deduction for a partially worthless debt when the terms
of a debt instrument have been modified.
The regulations provide guidance to certain taxpayers that have
claimed a deduction for a partially worthless debt and then modified
the terms of the debt instrument. This document also contains
regulations relating to certain assignments of notional principal
contracts by dealers in those contracts. The regulations provide
guidance to taxpayers relating to the consequences of these
DATES: Effective date: These regulations are effective January 29,
Applicability date: These regulations apply to significant
modifications of debt instruments and assignments of interest rate
swaps, commodity swaps, and other notional principal contracts
occurring on or after September 23, 1996.
FOR FURTHER INFORMATION CONTACT: Concerning the modifications of bad
debts, Craig Wojay, (202) 622-3920, and concerning dealer
assignments of notional principal contracts, Thomas M. Preston,
(202) 622-3940 (not toll-free numbers).
On June 25, 1996, temporary regulations (TD 8676) relating to
modifications of bad debts and dealer assignments of notional
principal contracts under sections 166 and 1001 of the Internal
Revenue Code (Code) were published in the Federal Register (61 FR
32653). A notice of proposed rulemaking (REG-209743-94, formerly
FI-59-94) cross-referencing the temporary regulations was published
in the Federal Register for the same day (61 FR 32728). No public
hearing was requested or held.
Written comments responding to the notice were received. After
consideration of the comments, the regulations proposed by
REG-209743-94 are adopted by this Treasury decision, and the
corresponding temporary regulations are removed.
Explanation of Provisions
The preamble to the temporary regulations sets forth limited
circumstances under which a taxpayer will be permitted to deduct an
amount on account of a partially worthless debt even though an
amount has not been charged off within the taxable year.
Section 166(a)(2) and §1.166-3(a) provide that a deduction for a
partially worthless debt is allowed only to the extent the debt is
charged off in the taxable year. The charge-off requirement is
satisfied when a portion of the debt is removed from the taxpayer's
books and records. This generally is accomplished by reducing the
debt's book basis.
Thus, when an amount has been deducted for partial worthlessness,
there is generally a reduction of both the book basis and the tax
basis of a debt.
When a taxpayer is required to recognize gain under §1.1001-1
because of a modification of a debt instrument, the taxpayer's tax
basis in the debt is increased by the amount of gain recognized.
However, regulatory and general accounting principles generally
would not permit a corresponding increase in the book basis of the
Because the prior charge-off is not restored (that is, the book
basis of the debt is not increased), there is no opportunity for the
taxpayer to take a new charge-off for pre-existing worthlessness.
The purpose of the temporary regulations is to preserve a portion of
a taxpayer's bad debt deduction with respect to a partially
worthless debt. The portion preserved corresponds to the amount the
taxpayer would have been entitled to deduct for partial
worthlessness with respect to the modified debt if the book basis of
the modified debt were increased to the same extent as the tax basis
of that debt. Thus, if all the conditions of the temporary
regulations are satisfied, then a modified debt is deemed to have
been charged off in the year in which gain is recognized. The amount
of the deemed charge-off, however, is limited to the difference
between the tax basis of the debt and the greater of the book basis
or the fair market value of the debt. The temporary regulations also
address debt that constitutes transferred basis property under
In addition, the temporary regulations provide a limited rule
dealing with a dealer's assignment of its position in an interest
rate swap, commodity swap, or other notional principal contract to
another dealer. If the assignment is permitted by the terms of the
contract, the assignment is not treated as a deemed exchange by the
nonassigning party of the original contract for a new contract that
differs materially either in kind or in extent. Thus, an assignment
to which the rule applies does not trigger gain or loss to the
Three comments were received on the §1.166-3T regulations. The first
comment requests a deemed charge-off for a taxpayer that purchased
at a discount debt for which a previous deduction for partial
worthlessness was claimed, and then significantly modified the debt
under §1.1001-3 and recognized gain on the modification. Whenever
debt is purchased for less than the stated redemption price,
recognized gain from a significant modification is attributable to
market discount as defined in section 1278(a)(2)(A) and not to a
previously claimed deduction for partial worthlessness. In addition,
the temporary regulations refer to §1.166-3(a)(1) and (2) for
guidance relating to prior charge-offs and deductions for partial
worthlessness. Extending the temporary regulations to cover a
discount purchase would significantly expand the regulations beyond
their intended scope and create a situation that would be extremely
difficult to administer.
The regulations do not adopt the request to extend the regulations
to cover such a purchase.
The second comment requests a deemed charge-off for a member of a
consolidated group that purchased debt, for which a previous
deduction for partial worthlessness was claimed, from another member
of the group, then significantly modified the debt under §1.1001-3
and recognized gain on the modification. Whenever debt is purchased
for less than the stated redemption price, subsequently recognized
gain from a significant modification is attributable to market
discount as defined in section 1278(a)(2)(A) and not to a previously
claimed deduction for partial worthlessness. Extending the temporary
regulations to cover a purchase from another member of the
consolidated group would significantly expand the regulations beyond
their intended scope. The regulations do not adopt the request to
extend the regulations to cover an intercompany transaction.
The third comment requests expanding the temporary regulations to
include other situations in which a taxpayer has tax basis in a debt
but no corresponding book basis.
The first situation involves the accrual of interest income on loans
that have been placed on non-accrual status for book purposes. The
second situation involves the requirement to accrue interest on
original issue discount obligations even if the loan has become
uncollectible. This comment deals with situations other than the
modification of a debt instrument and is beyond the scope of this
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and
because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Internal
Revenue Code, the notice of proposed rulemaking preceding these
regulations was submitted to the Small Business Administration for
comment on its impact on small business.
The principal author of the regulations concerning the modifications
of bad debts is Craig Wojay, Office of the Assistant Chief Counsel
(Financial Institutions and Products), IRS. The principal author of
the regulations concerning the dealer assignments of notional
principal contracts is Thomas M. Preston, Office of the Assistant
Chief Counsel (Financial Institutions and Products), IRS.
However, other personnel from the IRS and Treasury Department
participated in their development.
List of Subjects in 26 CFR Part 1 Income taxes, Reporting and
Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * * Par. 2. In §1.166-3, paragraph (a)
(3) is added to read as follows:
§1.166-3 Partial or total worthlessness.
(a) * * *
(3) Significantly modified debt--(i) Deemed charge-off.
If a significant modification of a debt instrument (within the
meaning of §1.1001-3) during a taxable year results in the
recognition of gain by a taxpayer under §1.1001-1(a), and if the
requirements of paragraph (a)(3)(ii) of this section are met, there
is a deemed charge-off of the debt during that taxable year in the
amount specified in paragraph (a)(3)(iii) of this section.
(ii) Requirements for deemed charge-off. A debt is deemed to have
been charged off only if--
(A) The taxpayer (or, in the case of a debt that constitutes
transferred basis property within the meaning of section 7701(a)
(43), a transferor taxpayer) has claimed a deduction for partial
worthlessness of the debt in any prior taxable year; and
(B) Each prior charge-off and deduction for partial worthlessness
satisfied the requirements of paragraphs (a)(1) and (2) of this
(iii) Amount of deemed charge-off. The amount of the deemed charge-
off, if any, is the amount by which the tax basis of the debt
exceeds the greater of the fair market value of the debt or the
amount of the debt recorded on the taxpayer's books and records
reduced as appropriate for a specific allowance for loan losses. The
amount of the deemed charge-off, however, may not exceed the amount
of recognized gain described in paragraph (a)(3)(i) of this section.
(iv) Effective date. This paragraph (a)(3) applies to significant
modifications of debt instruments occurring on or after September
* * * * *
§1.166-3T [Removed] Par. 3. Section 1.166-3T is removed.
Par. 4. Section 1.1001-4 is added to read as follows:
§1.1001-4 Modifications of certain notional principal contracts.
(a) Dealer assignments. For purposes of §1.1001-1(a), the
substitution of a new party on an interest rate or commodity swap,
or other notional principal contract (as defined in §1.446-3(c)(1)),
is not treated as a deemed exchange by the nonassigning party of the
original contract for a modified contract that differs materially
either in kind or in extent if--
(1) The party assigning its rights and obligations under the
contract and the party to which the rights and obligations are
assigned are both dealers in notional principal contracts, as
defined in §1.446-3(c)(4)(iii); and
(2) The terms of the contract permit the substitution.
(b) Effective date. This section applies to assignments of interest
rate swaps, commodity swaps, and other notional principal contracts
occurring on or after September 23, 1996.
§1.1001-4T [Removed] Par. 5. Section 1.1001-4T is removed.
Michael P. Dolan
Deputy Commissioner of Internal Revenue
Donald C. Lubick
Assistant Secretary of the Treasury
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