Proposed Regs Address Tax Implications of LIBOR Elimination
Proposed regulations provide guidance on the potential tax consequences of replacing the London interbank offered rates (LIBORs) with a new reference rate in contracts and agreements.
On July 27, 2017, the U.K. Financial Conduct Authority announced that all currency and term variants of the LIBORs may be phased out after 2021. On March 5, 2018, the Alternative Reference Rates Committee (ARRC) established that the Secured Overnight Financing Rate (SOFR) would replace the LIBOR within the United States.
Because the LIBORs are being phased out, existing debt instruments and derivatives must be amended. Parties will either amend debt instruments or contracts to replace references to the LIBOR with the SOFR (if in the United States). Alternatively, parties may alter debt instruments or contracts to replace the LIBOR-referencing fallback rate with another fallback rate upon the cessation of the LIBOR.
The ARRC has expressed several concerns to the IRS about the potential tax consequences associated with these contract amendments:
- Modification of Terms of Debt and Non-Debt Instruments. Currently, there are no regulations under Code Sec. 1001 that address when a modification of a debt instrument, derivative, or other non-debt contract creates a realization event.
- Transactions and Hedges. Amending the LIBOR-referencing debt instrument or hedge may cause a deemed termination of the hedge, which could lead to undesirable tax consequences.
- Character of a One-Time Payment. Parties may need to agree to a one-time payment to address any differences between the LIBOR and the new rate, and it is unclear what the character of this payment would be.
- Grandfathered Agreements. Certain debt and non-debt instruments that are exempt from specific laws due to their grandfathered status may lose that status if they are modified to reflect the elimination of the LIBOR.
- OID and Qualified Floating Rates. The transition from the LIBOR to the SOFR (or other alternative rates) raises potential issues under the original issue discount (OID) rules.
- REMICs. The modification of the terms of the regular interest rate in a real estate mortgage investment conduit (REMIC) to deal with the elimination of the LIBOR could preclude the interest from being a regular interest.
- Interest in Foreign Corporations. The elimination of the LIBOR could prevent a foreign bank from taking advantage of the election under Reg. §1.882-5(d)(5)(ii)(B).
Modification of Debt Instruments, Non-Debt Contracts
Under Proposed Reg. §1.1001-6(a), if the terms of a debt instrument or non-debt contract are modified to replace, or to provide a fallback to, an LIBOR-referencing rate and the modification does not change the fair market value, there is no gain or loss under Code Sec. 1001. These rules apply regardless of whether the modification occurs by an amendment to the terms of the instrument or agreement or by replacing the existing debt instrument or contract with a new one.
Furthermore, altering the debt instrument’s terms to replace the LIBOR with a qualified rate is not treated as a modification and does not result in a deemed exchange of the debt instrument under Reg. §1001-3. Likewise, an alteration to a debt instrument’s terms to include a qualified rate (see below) as a fallback to an LIBOR referencing rate is not treated as a modification and therefore does not result in an exchange of the debt instrument for purposes of Reg. §1.1001-3.
Proposed Reg. §1.1001-6(b) provides the rules for determining whether a rate is a qualified rate. To be a qualified rate, Proposed Reg. §1.1001-6(b)(2)(i) requires that the fair market value of the debt instrument or non-debt contract after the modifications must be substantially equivalent to the fair market value before that alteration or modification. The proposed regulations provide that the fair market value of a debt instrument or derivative may be determined by any reasonable valuation method, as long as that method is applied consistently and takes into account any one-time payment made in lieu of a spread adjustment.
The proposed regulations provide two safe harbors to address the fair market value requirements. The debt instrument or non-debt contract are considered equivalent in value after the modification if:
- at the time of the modification, the historic average of the LIBOR-referencing rate is within 25 basis points of the historic average of the rate that replaces it; or
- the parties to the debt instrument or non-debt contract are not related and, through bona fide, arm’s length negotiations, determine that the fair market value of modified instrument or contract is substantially equivalent to the fair market value prior to the modification.
Transactions and Hedges
Proposed Reg. §1.1001-6(c) clarifies that a taxpayer can alter the terms of a debt instrument or modify one or more of the other components of an integrated or hedged transaction to replace a rate referencing an IBOR with a qualified rate without affecting the tax treatment of either the underlying transaction or the hedge. However, the integrated or hedged transaction as modified must continue to qualify for integration.
Under Proposed Reg. §1.1001-6(d), the source and character of a one-time payment that is made in connection with a modification described above will be the same as the source and character that would otherwise apply to a payment made by a payor with respect to the debt instrument or non-debt contract that is altered or modified.
Because Proposed Reg. §1.1001-6(a) prevents debt instruments and non-debt contracts from being treated as reissued following a deemed exchange under Code Sec. 1001, the debt instrument or contract would not lose its grandfathered status as a result of any modifications made in connection with the elimination of an LIBOR.
OID and Qualified Floating Rate
Proposed Reg. §1.1275-2(m) stipulates three special rules for determining the amount and accrual of OID in the case of a variable rate debt instrument that provides both for interest at an LIBOR-referencing qualified floating rate and for a fallback rate that is triggered when the LIBOR becomes unavailable or unreliable.
- The LIBOR-referencing qualified floating rate and the fallback rate are treated as a single qualified floating rate for purposes of Reg. §1.1275-5.
- The possibility that the relevant LIBOR will become unavailable or unreliable is treated as a remote contingency for purposes of Reg. §1.1275-2(h).
- Occurrence of the event that triggers activation of the fallback rate is not treated as a change in circumstances.
Proposed Reg. §1.860G-1(e) permits an interest in a REMIC to retain its status as a regular interest despite certain alterations and contingencies.
Foreign Corporation Interests
The proposed regulations amend the election in Reg. §1.882-5(d)(5)(ii)(B) to allow a foreign corporation that is a bank to compute interest expense attributable to excess U.S.-connected liabilities using a yearly average SOFR in addition to the 30-day LIBOR. This amendment would allow the foreign corporation bank to make the election even after the LIBOR is phased out.
The proposed regulations will apply to an alteration of the terms of a debt instrument or a modification to the terms of a non-debt contract that occurs on or after the date of publication of a Treasury Decision adopting those rules as final regulations in the Federal Register. A taxpayer may choose to apply the proposed regulations to alterations and modifications that occur before the regulations are finalized.