The World's Most Important Number: The IRS Addresses The Replacement Of LIBOR - Commodities/Derivatives/Stock Exchanges

The London Interbank Offer Rate ("LIBOR") was considered the most banal reference point in modern finance until 2012 when it was discovered that the rate was unreliable. And when $350 trillion of securities use the same index to determine payments, even the smallest tweak can (and did) result in extreme discontinuities in the financial markets. LIBOR has been so engrained in the worldwide financial system that notwithstanding these challenges, financial regulators will not discontinue publishing LIBOR until 2022. The resulting change in the reference rate on bonds and derivatives could have substantial unanticipated US federal income tax consequences.

On October 8, 2019, the US Internal Revenue Service (the "IRS") released proposed regulations (the "Proposed Regulations") addressing certain US federal tax consequences of replacing an interbank offered rate with a successor rate.¹ As discussed in more detail below, the Proposed Regulations generally provide (a) circumstances in which the replacement of an IBOR, such as LIBOR, with a fallback rate, or an addition of a fallback mechanic to an existing instrument, will not result in a deemed taxable exchange of the instrument under section 1001 of the Internal Revenue Code of 1986, as amended (the "Code"), (b) the source and character of any one-time payment associated with a replacement of an IBOR rate, (c) relief under the rules for real estate mortgage investment conduits ("REMICs"), and (d) some relief pursuant to specific tests under existing regulations governing variable rate debt instruments ("VRDIs").

Background

As noted above, LIBOR is slated to cease to be supported at the end of 2021. In response, many issuers are now including fallback provisions in their instruments designed to provide mechanics for replacing LIBOR when that day comes. Of particular relevance to LIBOR specifically, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (the "ARRC"). ARRC has proposed a fallback "waterfall" for various types of newly issued, dollardenominated LIBOR debt instruments.² These fallbacks have not yet gained sufficient adherence to be considered standard across the market, but their incidence is increasing. One of these rates, the Secured Overnight Financing Rate ("SOFR"), measures the cost of overnight borrowings through repo transactions collateralized with US Treasury securities. Unlike LIBOR, it is always based on actual transactions.

IBOR Replacements Under Section 1001

THE CONCERN

For debt instruments and other financial instruments, a main US federal income tax concern surrounding the replacement of an IBOR rate on an outstanding financial instrument is whether the replacement (or addition to include a fallback mechanic) results in a "significant modification." If the replacement or addition is a significant modification, holders of the debt instrument would have a deemed (potentially taxable) exchange of their "old" note for a "new" note. This deemed exchange could result in current gain recognition to a holder or counterparty.

An alteration of a legal right or obligation that occurs pursuant to the terms of a debt instrument is not a "modification." In addition, issuer and holder options that can be unilaterally exercised are generally not modifications (provided, in the case of a holder option that the exercise does not result in a deferral of, or reduction in, any scheduled payment of principal or interest). An option is unilateral only if, under the debt's terms or applicable law (i) there does not exist, at the time of exercise or as a result of exercise, a right in the other party to alter or terminate the debt instrument or to put the instrument to a person related (using a more than 50 percent standard) to the issuer, (ii) the exercise of the option does not require the consent of the other party, a related party or a court, and (iii) the exercise of the option does not require consideration unless on the debt instrument's issue date the consideration is a de minimis amount, a specified amount or based on a formula that uses objective financial information.

There are multiple tests for determining whether a modification is "significant," including a test measuring whether there has been a change in yield, which generally asks whether the annual yield on the "new" instrument differs from the annual yield of the "old" instrument by no more than the greater of 0.25 percent or 5 percent of the annual yield of the old instrument.

There is a similar concern for non-debt instruments, but there are no clearly defined tax rules for when a deemed exchange occurs on such instruments.

Without specific guidance on the replacement of an IBOR rate, in order to avoid a deemed exchange, parties were left with these imperfect exceptions which invariably create uncertainty in many circumstances.

THE APPROACH OF THE PROPOSED REGULATIONS

The IRS intends to provide a broad exemption when replacing an IBOR rate with a successor index. The Proposed Regulations provide for the circumstances in which the replacement of an IBOR rate by a "qualified rate," the alteration of terms of an instrument to add a fallback "qualified rate" for an IBOR rate, or the replacement of an IBOR rate that is itself a fallback, will not constitute a modification, and therefore will not result in a deemed (potentially taxable) exchange.

Footnotes

1 The Proposed Regulations are available at https://www.govinfo.gov/content/pkg/FR-2019-10- 09/pdf/2019-22042.pdf.

2 For a detailed discussion of the ARRC recommended waterfalls, some of the federal tax considerations of concern before the Proposed Regulations were issued, and the industry group letters to the IRS, see Brennan W. Young and Thomas A Humphreys, "Breaking Up With LIBOR," Tax Notes Federal (September 9, 2019).

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