Arnold & Porter Discusses U.S. Treasury’s Proposed Regulations on Tax Issues Regarding LIBOR’s End
On October 9, 2019, the US Department of the Treasury (Treasury Department) issued proposed regulations (Proposed Regulations) regarding tax issues relating to the anticipated discontinuance of the London interbank rate (LIBOR) after the 2021 calendar year. The Proposed Regulations are taxpayer-friendly and intended to prevent disruptions in the financial market.
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 LIBOR announced that it can only commit to sustain LIBOR until the end of the 2021 calendar year. At that point, all variants of LIBOR—and perhaps other interbank rates (IBORs) as well—likely will be discontinued or otherwise impaired. To address this issue, parties to financial instruments with an IBOR reference rate will need to revise such instruments either to (1) replace the IBOR reference rate with another rate or (2) incorporate fallback provisions that address the potential elimination of IBOR and provide a methodology for replacing the IBOR reference rate. In response to requests for guidance on the tax impact of such amendments and other tax issues expected to arise from the discontinuance of IBOR, the Treasury Department issued the Proposed Regulations.
General Tax Consequences of Amendments to Financial Instruments
Section 1001 of the US Internal Revenue Code of 1986, as amended (the Code), and the regulations promulgated thereunder by the Treasury Department provide rules for determining the amount and timing of recognition of gain or loss from the sale or exchange of property for US federal income tax purposes. These rules generally provide that a "significant modification" of a debt instrument is treated as a deemed taxable exchange of the original debt instrument for a modified debt instrument. Generally, a modification is any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument. However, a modification generally does not include an alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument. Changing the interest rate index referenced in a debt instrument, if no provision has been made in the terms of the debt instrument for such change, is an alteration of the terms of the debt instrument that could be treated as a "significant modification" and thereby result in a deemed taxable exchange for US federal income tax purposes. Similarly, the rules under Section 1001 of the Code generally provide that a modification of a non-debt contract could result in a deemed taxable exchange of the original contract for the modified contract, if the modification materially changes the contract in kind or extent.
To address these potential consequences as a result of the discontinuance of IBOR, the Proposed Regulations generally provide that if (1) the terms of a debt instrument are altered or the terms of a non-debt contract are modified to replace, or to provide a fallback to, an IBOR reference rate with certain alternative specified reference rates (set forth below); and (2) the alteration or modification does not change (a) the fair market value of the debt instrument or non-debt contract or (b) the currency of the reference rate, then the alteration or modification does not result in a deemed taxable exchange for US federal income tax purposes. A replacement or fallback rate that is incorporated pursuant to a modification or alteration that satisfies the foregoing conditions is referred to as a "qualified rate."
The Proposed Regulations also provide that "associated alterations" (or, in the case of non-debt contracts, "associated modifications") that are reasonably necessary to adopt or implement the replacement of, or a fallback to, the IBOR reference rate also will not be treated as deemed taxable exchanges for US federal income tax purposes. An associated alteration (or associated modification) includes a change to the interest calculation period or a change to the timing and frequency of determining rates and making interest payments (e.g., delaying payment dates to allow sufficient time to compute and pay interest at a qualified rate computed in arrears).
Under the Proposed Regulations, qualified rates include:
- The Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (SOFR).
- The Sterling Overnight Index Average (SONIA).
- The Tokyo Overnight Average Rate (TONOR or TONA).
- The Swiss Average Rate Overnight (SARON).
- The Canadian Overnight Repo Rate Average (CORRA).
- The Hong Kong Dollar Overnight Index (HONIA).
- The Interbank overnight cash rate administered by the Reserve Bank of Australia (RBA Cash Rate).
- The euro short-term rate administered by the European Central Bank (€STR).
- Any alternative, substitute or successor rate selected, endorsed or recommended by a central bank, reserve bank, monetary authority or similar institution (including any committee or working group thereof) as a replacement for an IBOR or its local currency equivalent in that jurisdiction.
- Any "qualified floating rate" that is not described in (1) through (9) above.
- Any rate that is determined by reference to a rate described in (1) through (10) above including a rate determined by adding or subtracting a specified number of basis points to or from the rate or by multiplying the rate by a specified number.
- Any rate identified as a qualified rate in future tax guidance.
A rate is a qualified rate only if the fair market value of the debt instrument or non-debt contract after the alteration or modification is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the alteration or modification.
The Proposed Regulations provide two safe harbors for satisfying the fair market value requirement. Under the first safe harbor, the requirement is satisfied if, at the time of the alteration or modification, the historic average of the IBOR reference rate is within 25 basis points of the historic average of the replacement rate. The Proposed Regulations impose limitations on the methods parties may use to compute the historic average. Under the second safe harbor, the requirement is satisfied if the parties to the debt instrument or non-debt contract are not related and, through bona fide, arm's length negotiations over the alteration or modification, determine that the fair market value of the debt instrument or non-debt contract is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the alteration or modification.
A qualified rate also must refer to an interest rate benchmark that is based on the transactions conducted in the same currency or are otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency as the interest rate benchmark that was referenced by the IBOR rate.
Other Tax Issues
The Proposed Regulations also provide taxpayer-friendly guidance on several other issues impacted by the anticipated discontinuance of IBOR. For example, in the context of a "real estate mortgage investment conduit" (REMIC) (i.e., a special purpose vehicle holding a fixed pool of mortgages that issues "residual interests" (effectively treated as equity in a pass-through entity for US federal income tax purposes) and "regular interests" (treated as debt for US federal income tax purposes)), there were concerns that the transition from IBOR to other reference rates would impact the ability of a "regular interest" to maintain its status as such, because a regular interest is required to have "fixed terms." The Proposed Regulations clarify that the status of a regular interest will not be impacted by any amendments to the terms thereof solely to replace, or add a fallback to, an IBOR rate with a qualified rate. The Proposed Regulations also provide guidance with respect to the transition from IBOR to other reference rates in various other contexts, including (1) "original issue discount" (OID) for "variable rate debt instruments"; (2) integrated instruments (i.e., certain debt instruments and hedges that, taken together, are treated as one synthetic instrument for US federal income tax purposes); and (3) determining the source and character of any one-time payments made in connection with the discontinuance of IBOR as compensation for any expected reduction in payments attributable to the difference between IBOR and the replacement reference rate.
Although the Proposed Regulations are not effective until finalized, a taxpayer generally can rely on them immediately, provided that the taxpayer and its affiliates apply the Proposed Regulations consistently.