Background
On Oct. 9, 2019, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) issued proposed regulations (the Proposed Regulations) providing taxpayers with broad and flexible guidance on the tax consequences of the anticipated transition away from the London Interbank Offered Rate (LIBOR) and other interbank offered rates (IBORs) frequently used as reference rates in a wide variety of debt instruments and other contracts. 1 It is estimated that $200 trillion of financial contracts and securities are tied to USD LIBOR, affecting small businesses, corporations, banks, broker dealers, consumers and investors, among others. The Proposed Regulations should generally be welcomed by all taxpayers who are parties to IBOR-referencing contracts.
LIBOR is expected to be phased out after the end of 2021 due to concerns about manipulation and the relative paucity of the underlying transactions used to determine the rate. The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York organized the Alternative Reference Rates Committee (the ARRC) to identify alternative reference rates and to develop plans to facilitate market acceptance of such rates to reduce the risk that the cessation of USD LIBOR could disrupt financial institutions and capital markets. The ARRC recommended the use of the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR. 2 Other jurisdictions have also sought to replace LIBOR and other relevant IBORs associated with their respective currencies.
The ARRC has indicated that existing debt instruments and derivatives providing for IBOR-based payments will require amendment to address the pending elimination of such reference rates. Such amendments are anticipated to take the form either of (i) an alteration of the relevant instrument to replace the IBOR-referencing rate with another rate or (ii) an alteration of the relevant instrument to include a fallback provision adopting an alternative reference rate or replace an existing IBOR-referencing fallback rate with another fallback rate upon the discontinuance of the relevant IBOR or at some other designated time. 3 In either case, it is expected that the rate replacing the IBOR-referencing rate may include adjustments to the spread above the base reference rate to account for anticipated differences between the two base reference rates and/or a one-time, lump-sum payment in lieu of such a spread adjustment.
The ARRC and others have requested guidance from Treasury and the Service to alleviate a number of potential tax issues arising in connection with the elimination of IBORs, including requests that a debt instrument, derivative or other contract not be treated as exchanged under Section 1001 when the terms of the instrument are amended to replace an IBOR-referencing rate or to include or alter a fallback rate, 4 and that SOFR and similar replacement rates for IBOR-referencing rates in other currencies be treated as permitted alternative reference rates to IBOR-referencing rates.
The Proposed Regulations are issued in response to such requests and by and large adopt the ARRC's recommendations, as described in greater detail below.
Section 1001 Generally
Section 1001 provides rules for determining the amount and recognition of gain or loss from the sale or other disposition of property. Gain or loss is generally recognized upon the exchange of property for other property differing materially either in kind or in extent.
A significant modification of a debt instrument will result in an exchange of such instrument for a modified instrument that differs materially either in kind or in extent for purposes of Section 1001. A modification of a debt instrument is generally any alteration of a legal right or obligation of the issuer or holder of the debt instrument unless such alteration occurs by operation of the instrument's terms. An alteration treated as a modification must then be tested for significance under Treasury Regulation § 1.1001-3(e). Absent guidance, changing the base reference rate in a U.S. dollar-denominated debt instrument from USD LIBOR to SOFR, or adding or modifying a fallback provision to address the possible elimination of an IBOR, conceivably could be treated as a significant modification and result in a recognition event under Section 1001 if no provision has been made in the terms of the instrument for such a change.
In general, no rules analogous to those described in the immediately preceding paragraph specifically address when a modification of a nondebt contract such as a derivative or lease creates a recognition event. The Preamble accompanying the Proposed Regulations notes that, absent guidance, modifying a nondebt contract to reflect the elimination of an IBOR (including by adding or modifying a fallback provision) could cause a deemed termination of the nondebt contract for tax purposes.
Proposed Treasury Regulation § 1.1001-6 generally provides that if the terms of a debt instrument or nondebt contract are altered or modified to replace, or provide or alter a fallback to, an IBOR-referencing rate with a "qualified rate," such alteration or modification (and any "associated" alterations or modifications, such as the addition of an obligation for a party to make a one-time payment to offset the change in value of a debt instrument resulting from replacement of the IBOR-referencing rate) will not result in recognition of income, gain, deduction or loss to any party thereto under Section 1001. This rule applies whether the alteration or modification occurs by an amendment to the terms of the existing instrument or by an exchange of a new instrument for the existing instrument.
A qualified rate is defined generally for this purpose by means of (i) a list of specifically identified rates (including SOFR), (ii) any alternative rate selected, endorsed or recommended by the central bank or similar institution as a replacement for an IBOR or its local currency equivalent in that jurisdiction, (iii) any rate determined by reference to such identified or alternative rates, and (iv) any rate identified as a qualified rate in published guidance.
A rate is a qualified rate only if the fair market value of the debt instrument or nondebt contract after an alteration or modification described in the Proposed Regulations is substantially equivalent to its fair market value prior thereto. In determining fair market value for this purpose, the parties may use any reasonable, consistently applied method, taking into account the value of any one-time payment as described above.
The Proposed Regulations provide two safe harbors upon which taxpayers may rely to establish substantial equivalence. The first safe harbor is satisfied if, on the date of the relevant alteration or modification, the historic average of the IBOR-referencing rate does not differ by more than 25 basis points from the historic average of the replacement rate, taking into account any spread or other adjustment to the rate and the value of any one-time payment. The historic average may be determined by using (i) an industrywide standard or (ii) any reasonable method taking into account every instance of the relevant rate published during a continuous period beginning no earlier than 10 years prior to the alteration or modification and ending no earlier than three months prior to the alteration or modification. The historic average must be determined consistently for both rates by the parties.
The second safe harbor is satisfied if the parties to the debt instrument or nondebt contract are not related (within the meaning of Section 267(b) or Section 707(b)(1)) and the parties determine, based on arm's-length negotiations, that the fair market value of the altered or modified contract or instrument is substantially equivalent to its fair market value prior to such alteration or modification, taking into account the value of any one-time payment.
In order for a rate to be a qualified rate, the interest rate benchmark to which it refers after alteration or modification of the debt instrument or nondebt contract and the IBOR to which the instrument or contract previously referred must be based on transactions conducted in the same currency.
Integrated Transactions and Hedges
Debt instruments and hedges may be treated in certain circumstances as an integrated instrument under the Code (e.g., Treasury Regulation § 1.1275-6 provides rules pursuant to which certain debt instruments and one or more hedges may be integrated for purposes of determining the character and timing of a taxpayer's income, gain, deduction or loss). Absent guidance, amending an instrument or corresponding hedge to address the elimination of an IBOR may cause a dissolution of the integrated instrument, resulting in adverse tax consequences for one or more parties to the transaction.
Proposed Treasury Regulation § 1.1001-6 provides that an alteration or modification of the terms of a debt instrument or derivative to replace an IBOR-referencing rate with a qualified rate on one or more legs of a transaction integrated under Treasury Regulation § 1.1275-6 is not treated as legging-out of the transaction, provided that the relevant hedge as modified otherwise continues to meet relevant requirements. Similar rules are proposed with respect to Treasury Regulation § 1.988-5 (relating to foreign currency transactions) and transactions subject to the hedge accounting rules under Treasury Regulation § 1.446-4, as well as hedging transactions for bonds integrated as qualified hedges under Treasury Regulation § 1.448-4(h) for purposes of the arbitrage investment restrictions applicable to certain tax-exempt and other tax-advantaged bonds.
Source and Character of One-Time Payments
Proposed Treasury Regulation § 1.1001-6 provides that, for all purposes of the Code, including the withholding rules, the source and character of a one-time payment made by a payor as compensation for any reduction in payments attributable to the differences between the IBOR and the new reference rate is the same as the source and character that would otherwise apply to a payment made by the payor under such instrument or contract. The Proposed Regulations do not address circumstances where such instruments or contracts could require multiple types of payments by a payor or where a one-time payment is made to a party that does not ordinarily receive payments during the term of the instrument or contract.
Grandfathered Debt Instruments and Nondebt Contracts
The Preamble generally provides that an alteration or modification of a debt instrument or a nondebt contract in accordance with the Proposed Regulations will not cause such instrument or contract to be treated as reissued. As a result, such altered or modified instrument or contract will not be subject to a statute or regulation from which it was previously exempt. Thus, for instance, a debt instrument grandfathered under Section 163(f) (relating to registration-required obligations) or Section 1471 (relating to FATCA) will remain grandfathered notwithstanding any alterations made in connection with elimination of an IBOR as described in the Proposed Regulations.
OID and Qualified Floating Rate
Treasury Regulation § 1.1275-5 provides rules for determining the amount and accrual of qualified stated interest and original issue discount (OID) with respect to a variable rate debt instrument (VRDI). A VRDI may provide for stated interest at one or more qualified floating rates (QFRs). In general, a variable rate is a QFR if variations in value of the rate are reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds. If a debt instrument provides for two or more QFRs that can reasonably be expected to have approximately the same values throughout the term of the instrument, the QFRs together constitute a single QFR. If a VRDI provides for stated interest at a single QFR, the amount of any OID that accrues may be determined under the rules generally applicable to fixed rate debt instruments.
Proposed Treasury Regulation § 1.1275-2(m) provides that the IBOR-referencing QFR and the fallback rate are treated as a single QFR for purposes of Treasury Regulation § 1.1275-5. The Proposed Regulations also provide that a VRDI will not be treated as retired and then reissued, with attendant tax consequences, when the relevant IBOR becomes unavailable and the rate changes to the fallback rate.
REMICs
Section 860G(a)(1) provides that a real estate mortgage investment conduit (REMIC) regular interest must be issued on the startup day with fixed terms. Moreover, interest payments thereon may be payable at a variable rate only as provided in regulations, and a regular interest must generally entitle the holder to receive a specified principal amount. Contributions to a REMIC after the startup day are generally subject to a tax equal to 100 percent of such amounts.
Proposed Treasury Regulation § 1.860G-1(e) provides a rule disregarding an alteration to a regular interest in a REMIC occurring after the startup day that replaces an IBOR-referencing rate with a qualified rate or that includes or substitutes a qualified rate as a fallback rate for purposes of determining whether such interest has fixed terms on the startup day. The Proposed Regulations also provide that an interest in a REMIC will not fail to qualify as a regular interest where an IBOR-referencing variable rate may be changed to a fixed rate or different variable rate in anticipation of the IBOR becoming unavailable or unreliable or the amount of payments of principal or interest with respect to such interest is reduced by reasonable costs incurred to implement an alteration or modification described therein. Moreover, if a party other than the REMIC pays reasonable costs incurred to implement any such alteration or modification, the payment will not be considered a contribution subject to the 100 percent tax.
Foreign Bank Interest Expense
Treasury Regulation §1.882-5 generally requires a foreign corporation to complete a three-step process to determine the amount of interest expense for each taxable year that is allocable under Section 882(c) to income effectively connected (or treated as effectively connected) with the foreign corporation's conduct of a trade or business within the United States. In general, if the amount of such corporation's U.S.-connected liabilities exceeds its U.S. booked liabilities, the amount of interest expense allocable to such income is determined by a formula, utilizing an interest rate based on the average U.S. dollar interest rate applicable to U.S. dollar liabilities on the books at its offices and branches outside the United States. An election under Treasury Regulation § 1.882-5(d)(5)(ii)(B) allows a foreign corporation that is a bank to compute interest expense attributable to such excess U.S.-connected liabilities by reference to a published average 30-day LIBOR. The Proposed Regulations substitute a yearly average SOFR for this reference to 30-day LIBOR.
Applicability Dates
The Proposed Regulations generally apply on or after the date the proposed rules are adopted as final regulations. However, except with respect to Proposed Treasury Regulation § 1.882-5(d)(5)(ii)(B), taxpayers may generally apply such Proposed Regulations before such date. 5
Footnotes
1. LIBOR is a globally accepted key benchmark interest rate based on the average interest rates at which a large number of international banks in London lend money to one another. The rate is published daily in five currencies, including the U.S. dollar (USD LIBOR).
2. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities and is based on approximately $1 trillion of transactions each day. SOFR is published each day on the Federal Reserve Bank of New York's website.
3. A fallback provision specifies what is to occur upon an IBOR's discontinuance or significant impairment as a reliable benchmark.
4. All section references are to sections of the Internal Revenue Code of 1986, as amended (the Code), unless otherwise indicated.
5. Taxpayers and their related parties (within the meaning of Sections 267(b) and 707(b)(1)) may apply Proposed Treasury Regulation § 1.1001-6 to alterations or modifications occurring before the date the Proposed Regulations are adopted as final regulations, provided that such taxpayers and related parties consistently apply the rules of Proposed Treasury Regulation § 1.1001-6 before such date.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
