Treasury Department Publishes Final Regulations Regarding the Transition from LIBOR to Other Reference Rates
LIBOR has been extensively used as an interest rate benchmark in debt instruments (such as loan agreements and bonds) and other financial instruments (such as swaps and other derivatives). In July 2017, the UK regulator tasked with overseeing the London Interbank Offer Rate (LIBOR) announced that publication of LIBOR may cease after the end of 2021. Therefore, contracts that use LIBOR or certain other Interbank Offered Rates (IBOR) as reference rates will need to be modified or amended to name a replacement rate, reference index or otherwise provide for a fallback rate. Various tax issues may arise when taxpayers modify contracts in anticipation of the discontinuance of LIBOR and other IBOR.
Section 1001 of the US Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder by the Treasury Department provide rules for determining the amount and recognition of gain or loss on the sale or exchange of property for US federal income tax purposes. Modifications or amendments to existing debt instruments to change the interest rate or the interest rate index of reference could be treated as a “significant modification” resulting in a deemed taxable exchange of the original debt instrument for a modified debt instrument. Additionally, modifications to terms of other contracts could be deemed to be a sale or exchange of property differing materially in kind or extent (i.e., an exchange of the original contract for the modified contract) also resulting in a deemed taxable exchange. Contract modifications also may give rise to tax issues under the rules for integrated transactions and hedging transactions, fast-pay stock and real estate mortgage investment conduits (REMICs).
To “minimize potential market disruption” and “to facilitate an orderly transition in connection with the discontinuation of LIBOR and other IBORs”, the Treasury Department and the Internal Revenue Service (IRS) published proposed regulations in October 2019 (Proposed Regulations). The Proposed Regulations generally provided that a contract modification made in anticipation of the discontinuance of an IBOR will be neither an exchange of property for other property differing materially in kind or in extent, nor a “significant modification” for US federal income tax purposes. The Proposed Regulations also provided adjustments to other tax rules outside of Section 1001 “to minimize the collateral consequences of the transition away from IBORs.”
In October 2020, the Treasury Department and IRS issued Revenue Procedure 2020-44, 2020-45 I.R.B. 991 to further support the adoption of IBOR fallback provisions, which generally provides that a modification within the scope of the revenue procedure is not treated as an exchange of property for other property differing materially in kind or extent for purposes of Section 1001.
On January 4, 2022, the Treasury Department and IRS issued final regulations (Final Regulations) containing further guidance on the tax consequences of the anticipated discontinuance of LIBOR and other IBORs. Although the Final Regulations and Proposed Regulations share many of the same fundamental rules, the Final Regulations differ from the Proposed Regulations primarily in that the Final Regulations seek to simplify the operative rules and streamline the relevant terminology. The Final Regulations adopt the term “covered modification” to describe modifications that will not result in a deemed taxable exchange for US federal income tax purposes, and also eliminate a requirement in the Proposed Regulations that the fair market value of a contract before and after a modification be substantially equivalent. The Final Regulations replace this fair market value requirement with a list (and examples of) modifications that are excluded from the definition of covered modification and are therefore “noncovered modifications.”
The Final Regulations
General Tax Consequences of Amendments to Financial Instruments
The Final Regulations generally provide that a “covered modification” of a contract is not treated as the exchange of property for other property differing materially in kind or extent that would result in a deemed taxable exchange for US federal income tax purposes under Section 1001 and the regulations promulgated thereunder.
A “covered modification” is a modification of the terms of a contract (such as a debt instrument, a derivative, stock, an insurance contract or a lease) with an operative rate, or fallback provision, that references a discontinued IBOR and that:
- replaces the operative rate that references a discontinued IBOR with a qualified rate and, if the parties so choose, adds an obligation for one party to make a qualified one-time payment;
- adds a qualified rate as a fallback to the operative rate that references a discontinued IBOR;
- replaces a fallback rate that references a discontinued IBOR with a qualified rate;
- makes any associated modifications with respect to those modifications of the operative rate or fallback provisions; and
- is not a noncovered modification.
A covered modification can be made in any form, such as an exchange of contracts or an amendment to an existing contract, and does not need to be evidenced by an express agreement (whether oral or written) or otherwise. An “associated modification” is a modification of the technical, administrative or operational terms of a contract that is reasonably necessary to adopt or to implement a covered modification and includes incidental cash payments intended to make up for small valuation differences resulting from a modification (but does not include one-time payments, discussed further below).
The Final Regulations list modifications that are excluded from the definition of covered modification and therefore are “noncovered modifications.” Such noncovered modifications change the amount or timing of the contractual cash flows of a contract and are made by the parties with an intent to: (i) induce one or more parties to perform any act necessary to consent to a covered modification, (ii) compensate one or more parties for a modification of a noncovered modification, (iii) grant a concession to a party to the contract because that party is experiencing financial difficulty or to account for the credit deterioration of another party to the contract, (iv) compensate one or more parties for a change in the rights or obligations that are not derived from the contract being modified, and/or (v) achieve an unreasonable result, as may be identified in future IRS guidance.
If a noncovered modification occurs contemporaneously with a covered modification, Section 1001 (and the regulations promulgated thereunder) will apply to determine whether the noncovered modification results in a deemed taxable exchange and for purposes of such analysis, the covered modification will be treated as part of the terms of the contract prior to the noncovered modification.
Eligible Qualified Rates
Under the Final Regulations an eligible “qualified rate” is:
- a qualified floating rate (such as the Secured Overnight Financing Rate (SOFR), the Sterling Overnight Index Average, the Tokyo Overnight Average Rate, the Swiss Average Rate Overnight, and the euro short-term rate administered by the European Central Bank);
- an alternative, substitute, or successor rate selected, endorsed, or recommended by the central bank, reserve bank, monetary authority, or similar institution (including any committee or working group thereof) as a replacement for a discontinued IBOR or its local currency equivalent in that jurisdiction;
- a rate selected, endorsed, or recommended by the Alternative Reference Rates Committee as a replacement for USD LIBOR, provided that the Federal Reserve Bank of New York is an ex officio member of the Alternative Reference Rates Committee at the time of the selection, endorsement, or recommendation;
- a rate that is determined by reference to a qualified rate described above, including by adding or subtracting a specified number of basis points to or from the rate or by multiplying the rate by a specified number; and
- a rate published as a “qualified rate” in IRS guidance.
A qualified rate may be comprised of more than one individual qualified rate, such as under a fallback waterfall, but each individual fallback rate must be an eligible qualified rate.
Other Tax Issues
Taxpayer-Friendly Rules for REMICs Adopted
The Final Regulations adopt the taxpayer-friendly rules provided in the Proposed Regulations for REMICs, so that an interest in a REMIC will not fail to qualify as a “regular interest” as a result of a covered modification. Additionally, a regular interest REMIC will not fail to qualify as such solely because (i) it is subject to a contingency whereby the amount of payments of principal or interest (or other similar amounts) with respect to the interest in the REMIC is reduced by reasonable costs incurred to effect a covered modification, or (ii) it is subject to a contingency whereby a rate that references a discontinued IBOR and is a variable rate may change to a fixed rate or a different variable rate in anticipation of the discontinuance.
90-Day Grace Period for Integrated and Qualified Hedging Transactions
The Final Regulations generally provide that a covered modification to a contract for an integrated transaction under Treasury Regulation Sections 1.1275-6, 1.988-5(a), or 1.148-4(h) (i.e., certain debt instruments and hedges that, taken together, are treated as one synthetic instrument for US federal income tax purposes) generally will not result in a legging out of the transaction, provided that within 90 days from the first covered modification, the debt instrument that results from such covered modification continues to qualify for integration. If, however, the hedge component of the integrated transaction does not qualify for integration within the 90-day period, the covered modification is treated as legging out as of the date of the covered modification. The Final Regulations also provide that “interim hedges” entered into to mitigate temporary mismatches may be integrated during the 90-day grace period without affecting the integrated transaction.
Coordination with Fast-Pay Stock Rules
The Final Regulations provide that a covered modification of stock is not a significant modification or change that would trigger the fast-pay stock rules. However, if a covered modification is made contemporaneously with a noncovered modification that results in a significant modification, both the covered and noncovered modification would be analyzed under the fast-pay stock rules.
Investment Trusts Retain Classification
The Final Regulations provide that a covered modification of a contract held by an investment trust, or of an ownership interest in an investment trust, will not manifest a power to vary the investment of the certificate holder. As such, the investment trust will not lose its classification as such as a result of a covered modification.
One-Time Payments Still Under Consideration
The Final Regulations do not address the tax consequences of one-time payments (i.e., single cash payments intended to compensate a party for all or part of the basis difference between the discontinued IBOR and the interest rate benchmark to which the replacement rate refers) and indicate that the IRS and Treasury Department still are considering how to best address this issue. Taxpayers may rely on the Proposed Regulations to determine the source and character of a qualified one-time payment under the Final Regulations while the rules remain under consideration.
The Final Regulations are effective for modifications occurring on or after March 7, 2022 but may be applied retroactively, provided that the taxpayer and all related parties apply the Final Regulations to all modifications of contracts that occur before March 7, 2022. The Final Regulations also are effective for regular interests in a REMIC issued on or after March 7, 2022, but taxpayers may choose to apply the Final Regulations to a regular interest issued before March 7, 2022.
© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.