On October 8, 2019, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released a pre-published version of proposed regulations addressing the principal tax consequences related to the planned elimination of interbank offered rates (Proposed Regulations). The Proposed Regulations provide that certain modifications of debt instruments, derivatives and other contracts implementing a change from an interbank offered rate (IBOR) to another qualified rate will not cause a taxable event for holders, issuers or counterparties.
IBORs are average rates at which certain banks can borrow in the interbank market that have been used to determine interest rates on a variety of financial products, such as loans, mortgages, and derivatives. The London Interbank Offered Rate (LIBOR) is the most common IBOR with approximately $200 trillion in contracts referencing U.S. dollar denominated LIBOR. Other examples of IBORs are the Euro Interbank Offered Rate, the Tokyo Interbank Offered Rate and the Canadian Dollar Offered Rate. Although widely used, financial regulators have been concerned about the reliability of IBORs. In 2017, the U.K. Financial Conduct Authority announced that it would not require banks to provide LIBOR submissions after 2021.
Many countries, including the United States, have been in the process of identifying alternative benchmark rates for LIBOR under the expectation that LIBOR may no longer be available after 2021. The Federal Reserve Board and the New York Fed convened a group of market participants, the Alternative Reference Rates Committee (ARRC), to identify an alternative reference rate and make recommendations to mitigate risks with respect to the cessation of LIBOR. In June 2017, ARRC identified the Secured Overnight Financing Rate (SOFR), a rate that measures the cost of borrowing cash overnight collateralized by Treasury securities, as the preferred benchmark replacement for the United States.
Section 1001 provides general rules regarding the realization of gain or loss from the sale or other disposition of property. Gain or loss is realized upon the exchange of property for other property differing materially either in kind or in extent. For debt instruments, Treas. Reg. § 1.1001-3(b) provides that a significant modification of the debt instrument results in an exchange of the original debt instrument for a modified debt instrument that differs materially either in kind or in extent. A modification is generally any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument. Absent guidance like the Proposed Regulations, market participants have expressed concern that modifications of debt instruments or other contracts, such as derivatives, to transition from LIBOR to an alternative reference rate could be viewed as an exchange of the original contract for the modified contract, which could result in the recognition of taxable gain or loss.
In April 2019, ARRC submitted a letter to Treasury and the IRS requesting guidance on many of the U.S. federal income tax issues raised by the transition from LIBOR and other IBORs to alternative reference rates. As part of a transition from an IBOR rate to an alternative reference rate, parties to a contract may: (i) modify the rate referenced in the contract; (ii) modify existing fallback provisions of the contract that determine the rate if the referenced IBOR is not available; or (iii) provide compensation through either spread adjustments or one-time payments for modifications to the referenced rate. In many cases, these changes could be considered modifications of the instrument absent the Proposed Regulations. In addition to the recognition of gain or loss for a holder, treatment of these modifications as significant modifications can have certain ancillary consequences, including the recognition by issuers of cancellation of indebtedness income or repurchase premium and the loss of a debt instrument’s grandfathered status for purposes of FATCA. Also, a change in reference rates raises issues with respect to the qualification of “real estate mortgage investment conduits” (REMICs) discussed below.
Overview of the Proposed Regulations
The Proposed Regulations provide welcome guidance to clarify that the transition from an IBOR to a qualified rate (an IBOR-related modification) is not a modification for purposes of section 1001. The Proposed Regulations also provide that neither debt instruments nor non-debt contracts will be considered modified for purposes of treating the obligations as grandfathered obligations under FATCA.
In addition, if regular interests issued by a REMIC are subject to one or more IBOR-related modifications, the interest in a REMIC retains its status as a regular interest despite certain alterations and contingencies.
IBOR-Related Modifications under Section 1001
The Proposed Regulations provide that an alteration of a debt instrument related to a change in the reference rate from an IBOR to an alternative rate will not be treated as a modification for purposes of Treas. Reg. § 1.1001-3 so long as certain requirements (discussed below) are satisfied. Additionally, with respect to non-debt contracts, such as derivatives, stocks, insurance contracts, and lease agreements, the Proposed Regulations clarify that a modification related to a change in the reference rate from an IBOR to an alternative rate will not be treated as the exchange of property for other property differing materially in kind or extent for purposes of Treas. Reg. § 1.1001-1(a) so long as similar requirements are satisfied. Further, an alteration or modification to the terms of a debt instrument or non-debt contract to include a rate other than an IBOR as a fallback rate generally will also not result in a taxable exchange under the Proposed Regulations.
In connection with an IBOR-related modification, the parties to a debt instrument or non-debt contract may also make any associated alteration or modification without causing the instrument to be modified for tax purposes. Under the Proposed Regulations, an associated alteration or modification is any change reasonably necessary to adopt or implement the change from an IBOR. These changes may include technical administrative, operation alterations or modifications, such as a change to the definition of interest period or a change to the timing and frequency of determining and making payments of interest. The Proposed Regulations also provide that an associated alteration or modification may include a one-time payment to the extent that the payment is in connection with the change from an IBOR and the payment offsets the change in value of the debt instrument or non-debt contract.
Under the Proposed Regulations, in order for non-modification treatment to apply, the alternative rate replacing an IBOR must be a qualified rate. A qualified rate includes SOFR, the Sterling Overnight Index Average, the Tokyo Overnight Average Rate, the Swiss Average Rate Overnight, the Canadian Overnight Repo Rate Average, the Hong Kong Dollar Overnight Index, the interbank overnight cash rate administered by the Reserve Bank of Australia, and the Euro short-term rate administered by the European Central Bank. A qualified rate may also include rates selected by certain regulatory authorities, a qualified floating rate under Treas. Reg. § 1.1275-5(b), rates determined by reference to a qualified rate, and rates identified in guidance published in the Internal Revenue Bulletin. The qualified rate used to replace an IBOR with respect to a particular contract must be based on transactions conducted in the same currency or reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds. Additionally, a change to the spread to the contract’s reference rate does not prevent the rate from being a qualified rate.
The Proposed Regulations also provide that a rate is only a qualified rate if the fair market value of the debt instrument or non-debt contract after the alteration, including any one-time payments, is substantially equivalent to the fair market value before the alteration. While the parties may use any reasonable valuation method for this purpose, the Proposed Regulations provide two safe harbors for determining whether the fair market value is substantially equivalent after the alteration.
Under the first safe harbor, the fair market value of a debt instrument or non-debt contract will be considered substantially equivalent before and after the alteration if the historic average of the IBOR rate does not differ by more than 25 basis points from the historic average of the replacement rate, taking into account any spread adjustments or one-time payments made as a result of the alteration. Historic averages may be determined using industry-wide standards, such as standards recommended by certain organizations. Additionally, historic averages may be determined under any reasonable method that takes into account every instance of the relevant rate published during a continuous period beginning 10 years before the alteration and ending no earlier than three months before the alteration.
Alternatively, if the parties to a debt instrument or non-debt contract are not related, and the parties determine based on arm’s-length negotiations that the fair market value of the contract before and after the alteration is substantially equivalent, the fair market value test is satisfied. The IRS may also provide additional circumstances as to when the fair market value test is satisfied in published guidance.
While an IBOR-related modification will not be considered a modification for purposes of section 1001, if the parties to a contract make other modifications contemporaneous to the change in the reference rate, those modifications are analyzed under existing guidance.
Source and Character of a One-Time Payment
The Proposed Regulations provide that the source and character of a one-time payment that is made in connection with an IBOR-related modification is the same as the source and character that would otherwise apply to a payment by the payor with respect to such debt instrument or contract. Notably, it is not clear how to apply this sourcing and character rule if different payments under the instrument may have different source and/or character.
Integrated Transactions and Hedges
The Proposed Regulations provide that an IBOR-related modification that is not treated as a modification under the rules set forth above that relates to one or more legs of a transaction that is integrated under Treas. Reg. § 1.988-5 (integration of a nonfunctional currency debt instrument and hedge) or Treas. Reg. § 1.1275-6 (integration of a qualifying debt instrument and hedge) will not be treated as a “legging out” of the integrated instrument so long as the applicable hedge as modified continues to meet the requirements of the relevant integration regime. Similarly, an IBOR-related modification of one or more legs of a transaction subject to hedge accounting under Treas. Reg. § 1.446-4 will not be treated as a disposition or termination of either leg of the transaction. Finally, the Proposed Regulations provide that an IBOR-related modification of a hedging transaction that is a qualified hedge under Treas. Reg. § 1.148-4(h) (relating to arbitrage investment restrictions for tax-exempt and tax-advantaged bonds) is not treated as a termination of the qualified hedge so long as it continues to meet the requirements of that regulation.
REMIC and Other Securitization Guidance
The Proposed Regulations provide three rules with respect to REMIC regular interests. First, an alteration that is described in Treas. Reg. § 1.1001-6(a)(1) or (3) of regular interests issued by a REMIC will be disregarded for purposes of the “startup day” rule. Second, an interest in a REMIC will not fail to qualify as a regular interest solely because it is subject to a contingency with respect to a change in the rate in anticipation of an IBOR becoming unavailable or unreliable. Finally, an interest in a REMIC will not fail to qualify as a regular interest solely because it is subject to a contingency with respect to a reduction for reasonable costs incurred to affect an alteration or modification described in the section 1001 rules (described above). In addition, any payment by a party other than the REMIC of expenses reasonably incurred in connection with any such alteration or modification will not be treated as a contribution for purposes of the 100% tax under section 860G(d) for contributions after the startup day. The Proposed Regulations do not provide any new rules with respect to “prohibited transactions” under section 860F(a)(2), although alterations of any qualified mortgages held by a REMIC that qualify under Treas. Reg. § 1.1001-6(a)(1) or (3) should not be treated as the disposition of a qualified mortgage. The Proposed Regulations also do not provide rules with respect to modifications of stripped bonds or coupons issued by a fixed investment trust.
Interest Expense of a Foreign Corporation
Under Treas. Reg. § 1.882-5(d)(5)(ii)(B), a foreign corporation that is a bank is permitted to elect a rate that references 30-day LIBOR when determining the interest expense attributable to excess U.S.-connected liabilities in computing the interest expense allocable to income effectively connected with a U.S. trade or business. The Proposed Regulations provide that taxpayers that are banks may elect to use the yearly average of SOFR in place of 30-day LIBOR in such instance without the consent of the IRS.
The Proposed Regulations provide welcome guidance that, in most cases, an alteration or modification related to a change from an IBOR rate to a new qualified rate will not be a taxable event. The Proposed Regulations generally are effective for modifications, alterations, and issuances that occur on or after the date of publication of final regulations. However, taxpayers may rely on the Proposed Regulations prior to the publication of final regulations so long as taxpayers and its related parties consistently apply the Proposed Regulations.