The Internal Revenue Service has recently proposed Treasury regulations that expand the definition of which debt instruments are treated as publicly traded.

Under current Treasury regulations, the amount used for determining the tax consequences (upon a sale or exchange) with respect to a debt instrument that is publicly issued or issued in exchange for publicly traded property is the amount you have to pay to acquire the debt or the publicly traded property (the "issue price"). If the new debt instrument is not "publicly traded," then its face amount is generally the issue price.

The proposed regulations expand the circumstances under which a debt instrument may be considered publicly traded. This is important because the issue price of a debt instrument in a debt-for-debt exchange (i.e., upon a substantial modification of the terms of a debt instrument) is used (i) by the issuer to determine the amount of cancellation of indebtedness income recognized and (ii) by the holder to determine the amount of gain recognized.

Under the proposed regulations, a newly-issued debt instrument, or the property it is issued for, will be considered publicly traded if, at any time during the period beginning 15 days before the issue date and ending 15 days after the issue date (the "testing period"), such newly-issued debt instrument, or the property it is issued for, is listed or traded on an exchange or secondary market with reasonably ascertainable prices or quotes.

The proposed regulations, however, contain an exception for smaller issuances of debt. Specifically, a debt instrument will not be treated as publicly traded if (i) each trade of such debt instrument during the testing period is for quantities of $1 million or less, and the aggregate amount of all such trades is $5 million or less, or (ii) the original stated principal amount of the debt issue is $50 million or less.

The proposed regulations would impact creditors and debtors that modify their debt obligations. Significant modifications result in deemed taxable exchanges of the original debt obligations for "new" modified debt obligations. In such a deemed exchange, a debtor must recognize cancellation of indebtedness income to the extent that the issue price of the "old" debt instrument exceeds the issue price of the "new" debt instrument and a holder of a debt instrument must recognize gain or loss equal to the difference between the issue price of the "new" debt and its adjusted basis in the debt instrument. Certain practitioners believe that gain realized by a creditor (who does not hold the debt as inventory) on the exchange of its debt instrument should qualify as an installment sale, thereby resulting in recognition only upon receipt of the cash.