Last week, the U.S. Department of the Treasury released proposed rules providing tax guidance around various LIBOR replacement issues. Long anticipated. The defenestration of LIBOR will leave considerable broken glass in its wake. Perhaps just so the tax professionals wouldn’t feel left out, the end of LIBOR will create a series of tax problems. Very briefly, changing the price index of a loan, and certainly a mortgage loan, might be a significant modification under the so-called 1001 Rules. The result of that? Without a fix from our friends at the IRS, that change may be deemed an exchange of an old financial asset for a new one, creating potential gain or loss, violating the REMIC requirement that pools be static and violating the provisions of the REMIC rules. Obviously, those adverse consequences under the tax code were not intended by anyone and it would seem that we ought to get a simple fix. Changing the index is not a significant modification and therefore none of the other follow-on bad things happen. The end.

While, as we’re sure everyone knows, it’s not that simple and the IRS, instead of saying, “you got it fellas, we’re good,” has given us 50 pages of new regulatory code speak. We suggest that you read our OnPoint and we certainly invite you to read the release, which is subject now to public comment, because it is critically important that we get this right. Here’s a spoiler alert, while the proposed rules basically work, they do create problems and issues which we urge the industry to address to see if we can get this right before the proposed rules go into effect.

Just to recap the bidding here, a significant modification of a debt instrument has real tax consequences. Here are two examples. First, if a modification of a debt instrument is a significant modification, there is a deemed exchange and the holder is required to recognize any gain or loss based on the changed value of the modified debt instrument. This is a big potential problem: if the debt instrument is held in a REMIC, the REMIC could fail; if the holder has phantom income as a result of a significant modification, they may be required to pay taxes on that amount; and if the debt instrument is held in a REIT, the holder might be subject to prohibited transactions tax. We could go on. Second, if there is a significant modification of a REMIC itself (i.e., the certificates, not the collateral), then the interests in the REMIC might no longer qualify as regular interests, which would cause the REMIC to fail. The proposed rules provide that certain alterations to debt instruments to replace LIBOR with a qualified rate (a “Qualified Rate”) will not be treated as modifications—meaning that the holder would entirely avoid the need to determine whether a significant modification has occurred.

What constitutes a modification (which would require you to analyze whether you are dealing with a significant modification) under the current rules is broader than what you might think (unless you are a tax lawyer). Under the current rules, if you amend your existing documents to add or change existing LIBOR fallbacks, you might have a modification. To the non-tax lawyer, that shouldn’t seem too surprising because there is an amendment. If the method in your documents used to implement a LIBOR replacement requires an amendment to existing documents, you might have a modification. That also is not surprising because, again, there’s an amendment. If you are the holder of a debt instrument and you replace LIBOR pursuant to the express terms of your transaction documents, that change might be a modification unless both: (1) the option to replace LIBOR is unilateral (e.g., the change does not require the consent or approval of the other party) and (2) the option does not result in a deferral of, or a reduction in, any scheduled payment of interest or principal. So even if your documents already provide for a LIBOR transition, under the current rules, you may need to analyze whether that transition itself is a modification for tax purposes.

The proposed rules provide that the transition from an interbank offered rate (like LIBOR) to a Qualified Rate (or the addition or presence of fallbacks from an interbank offered rate to a Qualified Rate) is not a modification for tax purposes if it is done according to the proposed rules. For a LIBOR replacement rate to count as a Qualified Rate under the proposed rules, three things need to be true. First, the replacement rate needs to be included on a list in the proposed rules (either by being named to the list or by satisfying general requirements for replacement rates). SOFR and rates derived from SOFR (including, for example, Compounded SOFR, as discussed in the preamble to the proposed rules) are specifically named as potential Qualified Rates. Term SOFR, which would be derived from a derivatives market based on SOFR, is not specifically named in the proposed rules. The proposed rules would, however, allow Term SOFR to be added to the list of named potential Qualified Rates later if either the ARRC recommends it or it is added to the list by an Internal Revenue Bulletin. Other rates like the Prime Rate or the Federal Funds Rate (or even Term SOFR) that are not named Qualified Rates could also be included on the list if they satisfy requirements of a “qualified floating rate” under another section of the current rules.

By the way, common practice for LIBOR fallback language in existing debt instruments might not satisfy the separate qualified floating rate requirements. For example, one requirement is that the fallback rate is not subject to any floor unless the floor is fixed throughout the term of the related debt instrument. The LIBOR fallback language in some debt instruments set a replacement rate floor on the date of transition; there is an argument that this doesn’t count as the rate having a fixed floor for the entire term.

Rates that are specifically named in the proposed rules, like SOFR and Compounded SOFR, are not subject to the requirements of qualified floating rates—the preamble to the proposed rules states that the specifically named rates are in fact qualified floating rates. This is important for REMIC qualification of both debt instruments held by a REMIC and interests in the REMIC issued to investors, which generally must pay interest at either a fixed rate or a qualified floating rate. Another issue is that the proposed rules would not apply if your debt instrument switched from one fallback rate to another as, for example, many securitizations using ARRC-style fallback language do when they switch from Compounded SOFR to Term SOFR if Term SOFR later becomes available.

Second, for a LIBOR replacement rate to count as a Qualified Rate, the related altered debt instrument using the replacement rate must have a “substantially equivalent fair market value” to the unaltered debt instrument. This requirement is satisfied if, at the time of the alteration, the historic average of the proposed Qualified Rate (including any fixed spread adjustment added to this proposed Qualified Rate) is within 25 basis points of the related historic average of LIBOR. The parties may use any industry-wide standard (the proposed rules specifically name a standard recommended by the International Swaps and Derivatives Association (the “ISDA”) or the ARRC) or any other method that is reasonable and consistently applied so long as that method meets a few other requirements. It is worth noting that neither the ISDA nor the ARRC have publicly considered any methods to compute differences in the historic averages of LIBOR and a LIBOR replacement. Perhaps the proposed rules will be adjusted to count use of the ARRC or ISDA-recommended spread adjustment to satisfy this requirement.

Another way to satisfy the “substantially equivalent fair market value” requirement is if the parties to the debt instrument are not related and, through bona fide arm’s length negotiations, determine that the fair market value of the altered debt instrument is substantially equivalent to the fair market value of the debt in instrument before the alternation. This compliance route seems very broad and might be easy to satisfy. Could this requirement be addressed by including a recital or a representation in the related debt instrument or amendment?

The third criterion that a Qualified Rate must satisfy is that it must be based on transactions in the same currency the interbank offered rate it replaces used. For example, US dollar-based LIBOR could be replaced by US dollar-based Compounded SOFR but not by pound sterling-based SONIA.

The proposed rules also address something like the Benchmark Replacement Conforming Changes concept which appears in the ARRC’s recommended fallback language and which has started to become widely-adopted in the market. An “associated alteration” with respect to any of the above alterations (i.e., any Benchmark Replacement Conforming Changes) would not be considered a modification of the underlying debt instrument so long as the alteration is “reasonably necessary to adopt or implement” the change to a Qualified Rate. This is a different standard than the standard for Benchmark Replacement Conforming Changes that appears in the ARRC’s recommended fallback language. In the ARRC’s language, the lender (or other entity controlling the benchmark replacement process) would need to “decide” that the Benchmark Replacement Conforming Changes “may be appropriate to reflect the adoption and implementation” of the benchmark replacement and would “permit the administration thereof…in a manner substantially consistent with market practice….” It seems as though the proposed rules should include a carve-out for market practice (similar to the industry-wide standard used elsewhere in the rules?) in addition to the “reasonably necessary” standard. Further, any other alterations to a debt instrument made at the same time as any “associated alteration”, and which are not “reasonably necessary to adopt or implement” the change to a Qualified Rate, would need to be separately analyzed under the current rules (except that the pre-alteration debt instrument would be considered to include the terms of the LIBOR replacement alteration for purposes of the “significant modification” analysis). This presents a potential pitfall for the unwary—under the proposed rules, you would still need to analyze each of your Benchmark Replacement Conforming Changes separately to determine whether each is “reasonably necessary to adopt or implement” your LIBOR replacement.

The REMIC-specific changes in the proposed rules are worth considering carefully as well. The proposed rules provide that an alteration to a REMIC (remember our three examples: an amendment to add fallback language, an amendment to change the rate or the contractual switch from LIBOR to a fallback rate) that occurs after the startup day that provides for a switch to a Qualified Rate is disregarded in determining whether the REMIC has fixed terms on the startup day. In addition, an interest in a REMIC does not fail to qualify as a regular interest because it is subject to a contingency-qualified floating rate permitted under the REMIC rules.

The proposed rules are not clear that a contingency rate permitted under the REMIC rules automatically includes Qualified Rates; although the IRS stated in the preamble that the explicitly named possible Qualified Rates are qualified floating rates, any other potential Qualified Rate, such as any replacement index recommended by the ARRC in the future, would also need to be separately analyzed under the qualified floating rate requirements for REMIC qualification. Moreover, in the proposed REMIC rules, the safe harbor for LIBOR replacement alterations only applies to a contingency rate which would be applicable “in anticipation of [LIBOR] becoming unavailable or unreliable….” The language recommended by the ARRC, however, includes transition conditions related to actual unavailability of the rate (whether as a result of the administrator no longer publishing the rate or the insolvency of the rate’s administrator) or a public statement that LIBOR is unrepresentative by the applicable regulator. The proposed rules should line up more precisely with the language proposed by the ARRC which is already starting to be widely adopted by the market.

The proposed rules are a good start, even if they fall quite a bit short of entirely answering all tax questions connected with the LIBOR transition. Comments are due by November 25, 2019, so there there is still time to get technical fixes to the regulators before these proposed rules go live. While the ARRC and the trade groups are working on general comments and technical fixes, it is probably a good idea to review the proposed rules carefully yourself to understand how they might affect you and your business.