The U.S. Treasury Department and the Internal Revenue Service (IRS) recently issued proposed regulations providing guidance to taxpayers on the tax consequences of modifying financial instruments and contracts in advance of the upcoming phase-out of the London Interbank Offered Rate (LIBOR) and other interbank rates (collectively, IBORs).
These proposed regulations are intended to minimize potential market disruption and reduce tax uncertainty as global markets shift away from IBORs to alternative reference rates. In the absence of such guidance, changes to IBOR-denominated financial instruments and contracts as a result of the phase-out of IBORs could lead to the recognition by such holders of gains (or losses) and to potentially large tax liabilities. The proposed regulations provide broad and flexible tax guidance to help taxpayers avoid adverse tax consequences upon a modification of a financial instrument or contract to replace an IBOR-referencing rate with another rate.
General Non-Realization Rule. The proposed regulations generally provide that changes to a debt instrument, derivative contract or other affected contract, to replace a rate referencing an IBOR with a “qualified rate” (as defined in the proposed regulations) and any associated alteration or modification, will not result in a tax realization event under Section 1001 of the Internal Revenue Code and related regulations promulgated thereunder. A qualified rate includes several enumerated rates, including the Secured Overnight Financing Rate, as well as an alternative rate endorsed by a central bank or similar institution, provided, in each case, that the rate be substantially equivalent in fair market value to the replaced rate (the fair market value requirement). A taxpayer may use any reasonable, consistently applied method of valuation that takes into account the value of any one-time payment made in connection with the replacement of the IBOR-referencing rate to determine if the fair market value requirement is satisfied.
Safe Harbors for Fair Market Value Requirement. The IRS provided two safe harbors to assist taxpayers in satisfying the fair market value requirement. Under the first safe harbor, the fair market value requirement is satisfied if, at the time of the alteration or modification, the historic average of the IBOR-referencing rate is within 25 basis points of the historic average of the rate that replaces it. The second safe harbor is available if the parties to the instrument or contract are not related (generally, less than 50 percent common ownership) and the parties determine — based on bona fide, arm’s length negotiations — that the fair market value of the altered instrument or contract is substantially equivalent to the fair market value of the instrument or contract before the alteration or modification.
Source and Character Treatment. The proposed regulations also provide that the source and character of any one-time payment made by the borrower in connection with an alteration or modification of a debt instrument or non-debt contract is the same as the source and character that would otherwise apply to a payment made by the borrower with respect to the debt instrument or non-debt contract that is altered or modified. The Treasury Department and the IRS generally expect that a replacement rate will be lower than the IBOR-referenced rate and would typically result in the borrower making a one-time payment to the lender. Consequently, the proposed regulations did not provide for the treatment of one-time payments made by a lender in connection with the modification of an instrument.
Timing and Classification Considerations. The transition away from IBOR-referenced rates may also affect the timing and amount of original issue discount on a debt instrument and the classification of debt instruments as either variable rate debt instruments or contingent payment debt instruments. In general, the proposed regulations help taxpayers avoid causing an adverse recharacterization of a debt instrument as a contingent payment debt instrument or causing an increase in the amount of original issue discount recognized when the interest rate benchmark is transitioned away from an IBOR-referenced rate. Similar rules were proposed with respect to regular interests in a real estate mortgage investment conduit and in computing interest expense of foreign corporations.
Effective Date. In general, the proposed regulations apply to issuances, modifications and alterations of affected instruments that occur on or after the date the Treasury Department adopts these rules as final regulations. Taxpayers may, however, choose to apply the proposed regulations to modifications and alterations that occur prior to that date, provided that they apply the proposed regulations consistently.