Since the announcement was made that the London Interbank Offered Rate (LIBOR) was to be discontinued, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have released three pieces of guidance relating to whether an amendment to a contract to address the planned discontinuance of LIBOR results in a deemed taxable exchange of the contract for US federal income tax purposes.
The first of these were proposed regulations issued in October 2019 (the Proposed Regulations). The Proposed Regulations generally provide that an amendment to a contract to change a rate referencing an interbank offered rate (IBOR) to one of several listed “qualified rates” does not result in a deemed taxable exchange if the fair market value of the contract, as amended, is substantially equivalent to its fair market value prior to amendment. Additional amendments associated with the change to a qualified rate and one-time payments made to offset the change in value were similarly able to be made without triggering a deemed taxable exchange.
The IRS also released Rev. Proc. 2020-44, which provided an additional safe harbor. Under the revenue procedure, if a contract was amended to incorporate certain fallback language proposed by the Alternative Reference Rates Committee (ARRC) or the International Swaps and Derivatives Association (ISDA), such an amendment would not result in a deemed taxable exchange.
On December 30, 2021, Treasury and the IRS issued regulations finalizing the Proposed Regulations (the Final Regulations). The Final Regulations generally are consistent with the Proposed Regulations, but provide additional flexibility, including:
- Added guidance addressing waterfalls of qualified rates;
- Removed the fair market value requirement and added certain exclusions with respect to which modifications are permitted; and
- Added more granular guidance, as compared to the Proposed Regulations, to address certain situations that would otherwise negatively impact the qualification and tax consequences pertaining to integrated and hedging transactions.
Consistent with the Proposed Regulations, the Final Regulations provide that an amendment to the terms of a contract to change from an IBOR-referencing rate to certain “qualified rates” do not result in a taxable exchange. The Final Regulations accomplish this by providing that a taxable event will not result if the modification constitutes a “covered modification,” subject to certain exclusions.
A “covered modification” under the Final Regulations generally is defined as a modification that falls into one of three categories:
- The terms of the contract are modified to replace an operative rate that references a discontinued IBOR with a “qualified rate,” to add an obligation for one party to make a qualified one-time payment (if any), and to make associated modifications (if any);
- The terms of the contract are modified to include a “qualified rate” as a fallback to an operative rate that references a discontinued IBOR and to make associated modifications (if any); or
- The terms of the contract are modified to replace a fallback rate that references a discontinued IBOR with a “qualified rate” and to make associated modifications (if any),
provided that the modification is not excluded from the definition of a “covered modification,” as discussed below. The term also includes modifications described in section 4.02 of Rev. Proc. 2020-44.
Also consistent with the Proposed Regulations, a rate generally is a “qualified rate” if variations in the value of the rate can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency. The Final Regulations note that examples of qualified rates include SOFR, SONIA, TONA, SONAR, and the euro short-term rate administered by the European Central Bank, as well as rates determined by adding or subtracting basis points to or from the rate or by multiplying the rate by a specified number.
The Final Regulations also add flexibility to the definition of a “qualified rate” by providing that a qualified rate includes (1) an alternative rate selected, endorsed or recommended by a central bank or similar authority as a replacement for a discontinued IBOR or its local currency equivalent in that jurisdiction or (2) a rate selected, endorsed or recommend by ARRC as a replacement for USD LIBOR.
The Final Regulations further clarify that if multiple fallback rates are to be used (this arises, for example, in fallback language recommended by ARRC), each fallback rate must satisfy the requirements to be treated as a qualified rate. In addition, if it cannot be determined whether the fallback rate is a qualified rate at the time of the modification, which may occur if a contract is amended to provide that a calculation agent will determine the fallback rate at a later time based on certain factors, the fallback rate is not treated as a qualified rate. However, if the likelihood that a specific fallback rate will be used is remote at the time of testing, such a fallback rate is treated as satisfying the requirements to be a qualified rate.
The Proposed Regulations required that a “qualified rate” meet a fair market value requirement. The Final Regulations take a different approach and instead list specific modifications that are excluded from the definition of a “covered modification.” These exclusions include modifications where the terms of the contract are modified to change the amount or timing of contractual cash flows and are:
- intended to induce one or more parties to perform any act necessary to consent to a covered modification;
- intended to compensate one or more parties for a modification to the contract that is not a covered modification;
- either a concession granted to a party to the contract because that party is experiencing financial difficulty or a concession secured by a party to the contract to account for the credit deterioration of another party to the contract;
- intended to compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified; or
- identified in the Internal Revenue Bulletin as having a principal purpose of achieving a result that is unreasonable in light of the purpose of this section.
Various tax issues may arise in connection with modifications to contracts in anticipation of the discontinuation of LIBOR or other IBORs, including with respect to integrated and hedging transactions, fast-pay stock, and investment trusts.
Similar to the Proposed Regulations, the Final Regulations provide that a covered modification of one or more contracts (1) that are part of an integrated transaction under Treas. Reg. § 1.1275-6 is treated as not legging out of the integrated transaction or (2) that are part of a qualified hedging transaction under Treas. Reg. § 1.988-5(a) is not treated as legging out of the qualified hedging transaction. In addition, the Final Regulations provide (1) that a covered modification of one leg of a transaction subject to the hedge accounting rules of Treas. Reg. § 1.446-4 is not treated as a disposition or termination of either leg of the transaction and (2) that a covered modification of a qualified hedge or of the tax-advantaged bonds with which the qualified hedge is integrated under §1.148-4(h)(1) is treated as not terminating the qualified hedge under §1.148-4(h)(3)(iv)(B).
To address any lingering concerns regarding the application of the Proposed Regulations to modifications involving additions of or amendments to fallback provisions, the Final Regulations specially note that the definition of a covered modification includes the addition or amendment of fallback provisions. However, the IRS specifically cautions that any mismatch in the fallback provisions (in timing or amount) of the components of a transaction integrated under Treas. Reg. § 1.1275-6, Treas. Reg. § 1.988-5(a), Treas. Reg. § 1.446-4, or Treas. Reg. § 1.148-4(h) may result in the legging out of such transaction when one or more of those fallback provisions are triggered—in such a case, it would be necessary to first determine whether the Final Regulations apply to any modification that results from the triggered fallback provision(s).
The Final Regulations also add flexibility in providing a 90-day grace period to preserve integrated status. During this 90-day grace period, the modified components of an otherwise integrated transaction would not have to meet the integration qualifications, even if there were a mismatch in timing or amount during this time. The grace period begins on the date of the first covered modification of any component of the integrated transaction. However, if the hedge component of the integrated transaction does not qualify as a hedge by the end of the grace period, the covered modification will constitute a legging out as of the date of the covered modification. In addition, the Final Regulations provide that temporary hedges entered into to mitigate the economic effect of temporary mismatches may be integrated during the 90-day grace period without disrupting a transaction that is otherwise integrated.
Rules are currently in place to prevent the avoidance of tax by persons participating in certain fast-pay arrangements, defined as any arrangement in which a corporation has fast-pay stock outstanding for any part of its taxable year. Fast-pay stock is stock structured so that dividends (defined in section 316 of the Internal Revenue Code) paid by the corporation with respect to the stock are economically (in whole or in part) a return of the stockholder’s investment as opposed to only a return on the stockholder’s investment. The determination of whether stock is fast-pay stock is based on all relevant facts and circumstances. To prevent a covered modification of stock from inadvertently causing stock to satisfy the definition of fast-pay stock when the parties are attempting to address the discontinuation of IBOR, the Final Regulations provide that a covered modification is neither a significant modification nor a significant change for fast-pay determination purposes. However, the Final Regulations further provide that, if a covered modification and a non-covered modification are made at the same time or as part of the same plan and the non-covered modification is a significant modification of the terms of the stock or the related agreements or a significant change in the relevant facts and circumstances, then both the covered modification and the non-covered modification are considered in determining whether the stock constitutes fast-pay stock.
With respect to investment trusts, the Final Regulations provide that neither a covered modification of a contract held by an investment trust nor a covered modification of an ownership interest in the investment trust results in the manifestation of a power to vary the investment of the certificate holder.
The Final Regulations are effective as of March 5, 2022, but taxpayers may apply the Final Regulations retroactively, provided that all of the taxpayer’s related parties also apply the Final Regulations Retroactively.