Background

On July 27, 2017, the UK Financial Conduct Authority, the UK regulator tasked with overseeing the London interbank offered rate (LIBOR), announced that all currency and term variants of LIBOR, including U.S.-dollar LIBOR (USD LIBOR), may be phased out after the end of 2021. This announcement followed the UK’s adoption of the EU Benchmark Regulation in 2016, which imposed regulatory oversight of certain interbank offered rates (IBORs), including USD LIBOR. The sudden cessation of this reference rate in 2021 has the potential to cause considerable disruption in the marketplace and may adversely affect the normal functioning of a variety of markets in the United States due to the prevalence of USD LIBOR as a reference rate in a broad range of financial instruments.

Each jurisdiction is working toward replacing the LIBOR associated with its respective currency. The Secured Overnight Financing Rate (SOFR) has been selected by the U.S. Federal Reserve Board-convened Alternative Reference Rates Committee (ARRC) as the replacement rate for USD LIBOR. Existing debt instruments and derivatives providing for payments based on LIBOR or any other IBORs must be amended to address the potential elimination of those IBORs to the extent such debt instruments and derivatives do not otherwise provide for a functional fallback or replacement rate when LIBOR ceases. The ARRC indicated that these amendments will likely take one of two forms: (1) the parties may alter the instruments to replace the IBOR-referencing rate with another rate, such as one based on SOFR, or (2) the parties may alter the instruments to replace an IBOR-referencing fallback rate with another fallback rate upon the discontinuance of the IBOR or at some other appropriate time.

On October 8, 2019, the Department of the Treasury (Treasury) issued proposed regulations that provide guidance on the tax consequences of the transition to the use of reference rates other than IBORs in debt instruments and non-debt contracts. The proposed regulations address the possibility that an alteration of the terms of a debt instrument or a modification of the terms of non-debt contracts to replace an IBOR with a new reference rate could result in the realization of income, deduction, gain or loss for federal income tax purposes or could result in other tax consequences.

Alterations and Modifications to Debt Instruments and Non-Debt Contracts

Current Treasury regulations provide that a significant modification of a debt instrument results in a taxable exchange of the original debt instrument for a modified debt instrument that differs materially either in kind or in extent. There are no Treasury regulations that specifically address when a modification of a derivative or other non-debt contract creates a realization event. Thus, a change to the referenced interest rate index of a debt instrument or non-debt contract may be a significant modification causing a realization event for federal income tax purposes.

Alterations to Debt Instruments. The proposed regulations add new Treasury Regulations Section 1.1001-6, which provides that an alteration of the terms of a debt instrument to (i) replace a rate referencing an IBOR with a “qualified rate” (as described below) and any associated alteration, (ii) include a qualified rate as a fallback to a rate referencing an IBOR and any associated alteration or (iii) substitute a qualified rate in place of a rate referencing an IBOR as a fallback to another rate and any associated alteration (together with clause (i) and (ii), Qualified Alterations) are not treated as modifications and thus will not result in an exchange for purposes of Treasury Regulations Section 1.1001-3.

Modifications to Non-Debt Contracts. The proposed regulations also provide that a modification of the terms of a non-debt contract to (i) replace a rate referencing an IBOR with a “qualified rate” and any associated modification, (ii) include a qualified rate as a fallback to a rate referencing an IBOR and any associated modification or (iii) substitute a qualified rate in place of a rate referencing an IBOR as a fallback to another rate and any associated modification (together with clause (i) and (ii), Qualified Modifications) are not treated as the exchange of property for other property differing materially in kind or extent for purposes of Treasury Regulations Section 1.1001-1(a).

For purposes of the above rules, an “associated alteration” or “associated modification” is any alteration of a debt instrument or modification of a non-debt contract that is associated with an alteration or modification described in the two preceding paragraphs and is reasonably necessary to adopt or to implement the replacement or inclusion effected. An example of an associated alteration or associated modification is the addition of an obligation for one party to make a one-time payment in connection with the replacement of the IBOR-referencing rate with a qualified rate to offset the change in value of the debt instrument or non-debt contract that results from such replacement.

Qualified Rate. For a replacement rate to be a “qualified rate” for these purposes, it must be one of the listed rates provided in the proposed regulations1 and satisfy the Substantial Equivalence Requirement (as defined below) and currency requirement. Substantial Equivalence Requirement. A rate is a qualified rate only if the fair market value of the debt instrument or non-debt contract after the Qualified Alteration or Qualified Modification is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the Qualified Alteration or Qualified Modification (the Substantial Equivalence Requirement). In determining the fair market value, the parties may use any reasonable, consistently applied valuation method and must take into account the value of any one-time payment that is made in connection with the alteration or modification. A reasonable valuation method may (but need not) be based in whole or in part on past or projected values of the relevant rate.

The proposed regulations provide two safe harbors in meeting the Substantial Equivalence Requirement. The first safe harbor provides that the Substantial Equivalence Requirement is satisfied if at the time of the alteration the historic average of the IBOR-referencing rate is within 25 basis points of the historic average of the replacement rate. The second safe harbor provides that the Substantial Equivalence Requirement is met if the parties to the debt instrument or non-debt contract are not related and, through bona fide, arm’s length negotiations, determine that the fair market value of the debt instrument or non-debt contract before the Qualified Alteration or Qualified Modification is substantially equivalent to the fair market value of the instrument after the Qualified Alteration or Qualified Modification.

Currency Requirement. The currency test requires that the interest rate benchmark included in the replacement rate and the original IBOR rate are based on 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.

Other Alterations or Modifications. The proposed regulations provide a coordination rule in the event that a Qualified Alteration or Qualified Modification is made to a debt instrument or non-debt contract and other alterations or modifications that are not Qualified Alterations or Qualified Modifications are made as well. In such a case, the Qualified Alteration or Qualified Modification is treated as part of the existing terms of the debt instrument or non-debt contract and becomes part of the baseline against which the other alteration or modification is tested for purposes of determining whether a significant modification has occurred.

Integrated Transactions and Hedges

In certain circumstances, a debt instrument and one or more hedges may be treated as a single, integrated instrument for certain specified purposes under the Internal Revenue Code of 1986 (Code). Amending an IBOR-referencing debt instrument or hedge to address the elimination of the IBOR may result in a deemed termination or legging out of the integrated hedge that would have the effect of dissolving the integrated instrument into its component parts, which may result in adverse tax consequences or recognition events to parties of such instruments. In addition, timing rules that address the method of accounting for hedging transactions by requiring the matching of income, deduction, gain or loss attributable to hedging transactions with the timing of income, deduction, gain or loss from the item or items being hedged may be affected if an amendment to a debt instrument or hedge addressing the elimination of an IBOR results in a taxable exchange under Section 1001 of the Code.

Proposed Treatment of Integrated Transactions and Hedges. The proposed regulations provide that an alteration of the terms of a debt instrument or modification of the terms of a derivative to replace a rate referencing an IBOR with a qualified rate on one or more legs of the transaction will not be treated as legging-out of the transaction as long as the integrated or hedged transaction continues to qualify for integration under the applicable sections of the Code. In addition, for purposes of the timing rules that address the method of accounting for hedging transactions, altering the terms of a debt instrument or modifying the terms of a derivative to replace an IBOR-referencing rate with a qualified rate on one or more legs of the transaction will not be treated as a disposition or termination of either leg.

Source and Character of One-time Payment

Alterations to the terms of debt instruments or modifications to the terms of non-debt contracts to replace a rate referencing an IBOR may consist of not only the replacement of the IBOR with a new reference rate but also of an adjustment to the existing spread to account for the differences between the IBOR and the new reference rate. In addition to, or in lieu of, an adjustment to the spread, the parties may agree to a one-time payment as compensation for any reduction in payments attributable to the differences between the IBOR and new reference rate. Prior to the issuance of the proposed regulations, the source and character of this one-time payment were unclear under the Code.

Proposed Regulation on Source and Character. The proposed regulations provide that the source and character of a one-time payment made by a payor in connection with Qualified Alterations or Qualified Modifications to a debt instrument or non-debt contract will be the same as the source and character that would otherwise apply to a payment made by the payor with respect to the debt instrument or non-debt contract that is altered or modified. Treasury and the Internal Revenue Service (IRS) believe that one-time payments from lenders to borrowers will generally not occur since the difference in term and credit risk of the overnight, nearly risk-free rates that will generally replace the IBOR will usually result in a lower rate than the IBOR. Thus, if the IRS and Treasury determine that further guidance is needed, they will request further comments with respect to the source and character of payments received by a party (such as the borrower on a debt instrument or the lessee on a lease) that does not ordinarily receive payments during the term of the debt instrument or non-debt contract.

The proposed regulations described above in “Alterations and Modifications to Debt Instruments and Non-Debt Contracts,” “Integrated Transactions and Hedges” and “Source and Character of One-time Payment” apply to an alteration of the terms of a debt instrument or a modification of the terms of a non-debt contract that occurs on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. Taxpayers and their related parties may apply this section to an alteration of the terms of a debt instrument or a modification of the terms of a non-debt contract that occurs before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register, provided that the taxpayers and their related parties consistently apply the rules of this section before that date.

OID and Qualified Floating Rate

Certain questions under the original issue discount (OID) rules arise from the transition to alternative rates—specifically whether a debt instrument has OID, and the amount and accruals of OID over its term, will vary based on whether such debt instrument is treated as a variable rate debt instrument (VRDI) or a contingent payment debt instrument (CPDI). The determination of which treatment to apply will vary based on the stated interest rate and whether a contingency is deemed to be remote. In addition, if a contingency that is initially deemed to be remote actually occurs, then the debt instrument is treated as retired and reissued at such time for purposes of the OID rules. Thus, clarification is needed as to the treatment of contingencies and whether certain debt instruments that reference IBOR will qualify as VRDIs or will be subject to nonremote contingencies that must be taken into account.

Proposed VRDI Treatment. The proposed regulations set forth the following three special rules to determine the amount and accrual of OID in the case of a VRDI that provides for both interest at an IBOR-referencing qualified floating rate and a methodology to change the IBOR-referencing rate to a different rate in anticipation of the IBOR becoming unavailable or unreliable:

  1. The IBOR-referencing qualified floating rate and the different rate are treated as a single qualified floating rate for OID purposes.
  2. The possibility that the relevant IBOR will become unavailable or unreliable is treated as a remote contingency for OID purposes.
  3. The fact that the IBOR becomes unavailable or unreliable is not treated as a change in circumstances.

Thus, when the relevant IBOR becomes unavailable or unreliable and the rate changes, the VRDI is not treated as retired and reissued for OID purposes despite the fact that the possibility of the IBOR becoming unavailable or unreliable is a remote contingency. Otherwise, the OID regulations continue to apply to IBOR-referencing VRDIs as they would any other debt instrument. These rules are applicable to debt instruments issued on or after the date of publication of a Treasury decision adopting these rules as final regulations; however, taxpayers may rely on these rules prior to such date provided that the taxpayers consistently apply the rules of this section before that date.

Grandfathered Debt Instruments and Non-Debt Contracts

The requirements of certain sections of the Code and Treasury regulations do not apply to debt instruments and non-debt contracts issued before a specific date.

The proposed regulations imply that a debt instrument grandfathered under Section 163(f), 871(m) or 1471 of the Code will not lose its grandfathered status as a result of any Qualified Alteration because it will not be treated as reissued. Furthermore, the proposed regulations specifically state that a Qualified Modification to a non-debt contract is not a material modification for purposes of Treasury Regulations Section 1.1471-2(b)(iv).

These proposed regulations apply to an alteration of the terms of a debt instrument or a modification of the terms of a non-debt contract that occurs on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. Taxpayers and their related parties may apply this section to an alteration of the terms of a debt instrument or a modification of the terms of a non-debt contract that occurs before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register, provided that the taxpayers and their related parties consistently apply the rules of this section before that date.

Determination of Interest Deduction

A foreign corporation is required to determine its interest expense allocable to income that is effectively connected with the conduct of a trade or business within the United States. A foreign corporation could have U.S.-connected liabilities that exceed U.S.-booked liabilities (Excess U.S.-Connected Liabilities). When a foreign corporation that is a bank has Excess U.S.-Connected Liabilities, the bank may elect the interest rate of its Excess U.S.-Connected Liabilities to be a rate that references 30-day LIBOR only.

The proposed regulations amend this election to allow a foreign corporation that is a bank to compute interest expense attributable to Excess U.S.-Connected Liabilities using a yearly average SOFR.

These proposed regulations apply to taxable years ending after the date of publication of a Treasury decision adopting these rules as final regulations is published in the Federal Register.

Real Estate Mortgage Investment Conduits

Pursuant to the Code, a regular interest in a Real Estate Mortgage Investment Conduit (REMIC) must be issued on the startup day with fixed terms. Treasury regulations state that a regular interest in a REMIC has fixed terms on the startup day if, on the startup day, the REMIC’s organizational documents irrevocably specify, among other things, the interest rate or rates used to compute any interest payments on the regular interest. Consequently, a modification of the terms of the regular interest to change the rate or fallback provisions in anticipation of the cessation of an IBOR could preclude the interest from being a regular interest.

Also pursuant to the Code, interest payments on a regular interest in a REMIC may be payable at a variable rate only to the extent provided in Treasury regulations, and a regular interest must unconditionally entitle the holder to receive a specified principal amount. Treasury regulations describe the variable rates permitted for this purpose. Notwithstanding these limitations on the payment of principal and interest on a regular interest in a REMIC, Treasury regulations list certain contingencies affecting the payment of principal and interest that do not prevent an interest in a REMIC from being a regular interest. However, the list of excepted contingencies does not include a fallback rate that is triggered by an event, such as the elimination of an IBOR, that is likely to occur.

Subject to certain exceptions, a REMIC is subject to a tax equal to 100 percent of amounts contributed to a REMIC after the startup day. If a party other than the REMIC pays costs incurred by the REMIC after the startup day, that payment could be treated as a contribution to the REMIC subject to such tax.

For purposes of determining whether an interest in a REMIC is a regular interest, the proposed regulations provide that a Qualified Alteration that is made after the startup day is disregarded. In addition, an interest in a REMIC does not fail to qualify as a regular interest solely because 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 Qualified Alteration or Qualified Modification. Payment by a party other than the REMIC of reasonable costs incurred to effect a Qualified Alteration or Qualified Modification is not a contribution to the REMIC for purposes of the tax imposed under Section 860G(d) of the Code.

These proposed regulations apply with respect to an alteration or modification that occurs on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, taxpayers may apply these proposed regulations with respect to an alteration or a modification that occurs before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

Furthermore, the proposed regulations provide that an interest in a REMIC does not fail to qualify as a regular interest solely because it is subject to a contingency whereby a rate that references an IBOR and is a permitted variable rate may change to a fixed rate or a different permitted variable rate in anticipation of the IBOR becoming unavailable or unreliable.

This section of the proposed regulations applies to a regular interest in a REMIC issued on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, a taxpayer may apply this section to a regular interest in a REMIC issued before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.