United States: US IRS Releases Final Regulations Addressing IBOR Transition

As the IBOR transition continues, business teams have frequently heard from their tax departments and advisors that amending existing contracts to add IBOR replacement mechanics or replacing an IBOR rate with a new rate can have US tax consequences. The last major guidance from the Internal Revenue Service (the "IRS") on this subject came on October 8, 2019 (back when taking a day to work from home might have been presumed to be a light day) in the form of proposed regulations under section 1001 of the Code (the "Proposed Regulations").¹ The Proposed Regulations were not without imperfection. On December 30, 2021, the IRS published final regulations for the IBOR transition (the "Final Regulations").² Most importantly, as discussed in more detail below, the final version no longer contains the requirement in the Proposed Regulations that the fair market value of the instrument after the replacement or addition is substantially equivalent to the fair market value of the instrument before the replacement or addition, replacing that standard with a list of modifications that fall outside the relief provided by the Final Regulations.

This Legal Update begins with background on the principle US federal income tax concern with IBORrelated amendments to existing contracts and an overview of previous IRS guidance aimed at addressing the concern. We then discuss the types of modifications that can fit within the Final Regulations, the relief provided for modifications that do fit and a few questions left open by the IRS. 

I. Background

A. THE US TAX CONCERN

As a refresher, 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 the deemed exchange of the instrument for a deemed new instrument that differs materially in kind or in extent. This deemed exchange could result in current gain or loss recognition to a party to the instrument.³

In the debt context, a deemed exchange only occurs if the replacement or addition is a "significant modification."⁴ 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 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, specifically enumerated tests for determining whether a modification is "significant." For example, the test for measuring whether there has been a change in yield 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 modification to a non-debt instrument results in an instrument that differs materially in kind or in extent (and thus whether deemed exchange occurs upon the modification of such instruments).

B. EXISTING GUIDANCE

Until the Final Regulations came along, taxpayers had only the Proposed Regulations and Rev. Proc. 2020-44.

Under the Proposed Regulations, replacement of an IBOR (or the addition to an instrument of a fallback mechanic to replace an IBOR) generally did not result in a deemed exchange for US federal income tax purposes if: (i) the fallback rate was a qualifying rate (which was broadly defined), and (ii) the fair market value of the instrument after the replacement or addition was substantially equivalent to the fair market value of the instrument before the replacement or addition.⁵ The fair market value requirement caused the market some heartburn for a variety of reasons. The Proposed Regulations included two safe harbors, neither of which appeared to provide an ideal degree of certainty. As discussed in more detail below, the Final Regulations do away with the fair market value requirement in favor of the creation of a new category of modifications that are not covered by the Final Regulations and must be tested under prior law (including, for debt instruments, Treas. Reg. section 1.1001-3).

Under Rev. Proc. 2020-44, if an existing instrument was amended to include certain enumerated fallback mechanics published by the ARRC or ISDA, then that amendment was blessed as not resulting in a deemed exchange.⁶ The revenue procedure permits only limited deviations from the ARRC and ISDA fallback mechanics and only applies to the amendment of existing contracts (rather than using the fallback mechanics of a new instrument). As a result, the revenue procedure fell short of the ideal level of comfort. The revenue procedure was set to expire on December 31, 2022. As discussed below, the Final Regulations make the relief provided in the revenue procedure permanent. 

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Footnotes

1. All sections references are to the Internal Revenue Code of 1986, as amended (the "Code") and the Treasury regulations thereunder. 

2. The Final Regulations are available at https://public-inspection.federalregister.gov/2021-28452.pdf. The IRS released Rev. Proc. 2020-44 since the issuance of the Proposed Regulations, but that guidance only applied to limited and specific circumstances (as discussed in more detail below).

3. For a discussion of the potential recognition of loss under the wash sale rules, see Thomas A. Humphreys and Brennan W. Young, "The More Things Change, the More They Stay the Same? Losses in a Deemed Exchange and the Wash Sale Rules," Journal of Taxation of Financial Instruments, Volume 18 Issue 3, 2021.

4. Treas. Reg. section 1.1001-3. 

5. For a more detailed discussion of the Proposed Regulations, see our Legal Update, available at https://www.mayerbrown.com/en/perspectives-events/publications/2019/10/the-worlds-most-important-number-the-irs-addresses-the-replacement-of-libor.

6. For a more detailed discussion of Rev. Proc. 2020-44, see our Legal Update, available at https://www.mayerbrown.com/en/perspectives-events/publications/2020/10/limited-us-tax-guidance-for-adding-arrc-and-isda-fallbacks.

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