The More Things Change, the More They Stay the Same? Losses in a Deemed Exchange and the Wash Sale Rules

When tax lawyers toil over bond offerings (and write the accompanying prospectus disclosure) they often think about whether some current or future change in a bonds terms will trigger a deemed exchange of the bond for federal income tax purposes resulting in gain or loss to the unsuspecting bond holders. Commentators have suggested coordinating the Reg. 1.1001-3 significant modification and the Code Sec. 1091 "substantially identical" standards but neither Congress nor the courts have taken up the issue.5 I. Background a. Reg. 1.1001-3 The analysis begins with a summary of the types of changes to a debt instrument that the regulations under Reg. 1.1001-3 consider to constitute a "significant modification" that can result in a deemed exchange because the modified instrument differs materially either in kind or in extent from the original instrument.6 The regulations were published as a response to the Supreme Court's decision in Cottage Savings,7 and were meant to -ovide a framework for the types of changes to a debt instrument that would trigger a recognition event. Other parts of the J.S. federal tax law interpret the term "securities" to be limited, for example, excluding indebtedness that is shorter in tenor.21 In a handful of advice memoranda, the IRS interpreted the term "security" broadly for purposes of the wash sale rules, including under that umbrella Treasury bills, Treasury bill futures, Ginnie Mae participation certificates, and residual interests in REMICs.22 Critical for this undertaking is getting to the bottom of what it means for one security to be "substantially identical" to another. In Rev. Rul. 60-195, the Internal Revenue Service ruled that a change in interest rate is a change to a material feature for purposes of the "substantially identical" definition and that a 95 basis point increase is a change sufficient to result in a debt instrument that is not "substantially identical" to the instrument with lower interest rate, since there was a "substantial difference in interest rates.