On October 9, 2019, the US Treasury Department issued proposed regulations (Proposed Regulations) providing guidance and rules relating to the transition from interbank offered rates (IBORs) to other reference rates in both debt and non-debt instruments (generally, derivatives, stocks, insurance contracts and lease agreements). The Proposed Regulations principally address the concern that the change in these instruments from IBOR to other reference rates will be seen as a “significant modification” under the Treasury Regulation section 1.1001-3(b).
IBORs date back to the late 1960s and the London interbank offered rate (LIBOR) has become one of the most prevalent reference rates for debt and non-debt instruments alike. On July 27, 2017, the UK regulator tasked with overseeing LIBOR announced that all currency and term variants of LIBOR are likely to be phased out by the end of 2021. The Proposed Regulations address the following tax issues that may be implicated by the change from the LIBOR to an alternative reference rate.
Significant modification. Pursuant to Treasury Regulation section 1.1001-3(b), a change from LIBOR to other reference rate in a debt instrument or non-debt instrument could be considered a “significant modification,” the result potentially being a deemed taxable exchange of the instrument under Section 1001. To avoid this result, the Proposed Regulations provide that generally an “alteration of the terms of a debt instrument to replace a[n IBOR] with a qualified rate [defined below],” and the modification of the terms of a contract other than a debt instrument, are not treated as modifications, and therefore do not result in an exchange of the debt instrument for purposes of Treasury Regulation section 1.1001-3.
The Proposed Regulations define a “qualified rate” (QR) as any of (i) one of eight listed reference rates,1 (ii) LIBOR alternatives/replacements selected by central banks, (iii) any qualified floating rate as defined in Treasury Regulation section 1.1275-5(b), (iv) any rate determined by reference to any of the listed reference rates, or (v) any rate published in the Internal Revenue Bulletin. Further, any QR must also satisfy a “fair market value test” and a “currency test.”
Fair market value test. The fair market value test is satisfied if the fair market value of the debt instrument or non-debt contract after the relevant alteration or modification is substantially equivalent to the fair market value before that alteration or modification. The Proposed Regulations include two safe harbors which are: (i) 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 rate that replaces it; or (ii) if the parties to the debt instrument or non-debt contract are not related and, through bona fide, arm's length negotiations over the alteration or modification, determine that the fair market value of the altered debt instrument or modified non-debt contract is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the alteration or modification.
Currency test. The currency test is satisfied only if the interest rate benchmark to which the rate refers after the change, and the IBOR to which the debt instrument or non-debt contract referred before that change, 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.
The same non-recognition result in the Proposed Regulations is provided for “associated alterations” in debt instruments and “associated modifications” in non-debt instruments. However, if the associated alteration or associated modification is not related to the change from LIBOR to other reference rate, such alteration or modification will be analyzed under Treasury Regulation 1.1001-3.2
Integrated transactions and hedges. Another concern has been whether the alteration of a debt instrument or the terms of a derivative, as applicable, to replace an IBOR with a QR would change the tax treatment of certain related integrated transactions or hedges. The Proposed Regulations provide that the tax treatment of such integrated transactions or hedges would not change if the related transaction continues to qualify under the relevant Treasury regulations (Treasury Regulation sections 1.1275-6 and 1.988-5(a)) after the alteration.
Source of certain one-time payments. In connection with an alteration to shift from an IBOR to a new reference rate, there may be “one-time” payments to account for the differences between the IBOR and the new reference rate, and the costs associated with modifying the agreement. The Proposed Regulations generally provide that the source of any such one-time payment made in connection with the change from LIBOR to other reference rate will track 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.”3
Variable rate debt instruments. The Proposed Regulations also address the issue of whether the phase-out from IBORs would adversely affect certain variable rate debt instruments (VRDIs) that provide for interest at an IBOR-referencing qualified floating rate and for a fallback rate that is triggered when the IBOR becomes unavailable or unreliable. The Proposed Regulations provide that the occurrence of the event that triggers activation of the fallback rate is not treated as a change in circumstances, thereby avoiding the adverse tax consequences of treating the instrument as retired and reissued under Treasury Regulation section 1.1275-2(h)(6).
Regular REMIC interests. The Proposed Regulations generally provide that if the parties to a regular interest of a real estate mortgage investment conduit (as defined in Treasury Regulation section 1.860G-1(a)(4)) alter the terms after the startup day to replace an IBOR-referencing rate with a QR, or to make any other alteration described in Proposed Treasury Regulation sections 1.1001-6(a)(1) or 1.1001-6(a)(3), those alterations are disregarded for the purpose of determining whether the regular interest has fixed terms on the startup day.
Foreign corporate banks. The Proposed Regulations allow a foreign corporation that is a bank to compute interest expense attributable to excess US-connected liabilities using a yearly average SOFR.
Effective date of the proposed regulations. Although final regulations will be prospective only, taxpayers may generally rely on the Proposed Regulations for alterations and modifications that occur before that date, provided that the taxpayer consistently applies the rules before that date. Taxpayers should consider updating their instruments (debt and non-debt instruments alike) prior to the complete transition away from the LIBOR and should adjust existing transactions where appropriate. We will continue to monitor these developments closely.