Treasury and IRS Issue Final Tax Regulations for LIBOR Replacement Amendments – Finance and Banking

Treasury and IRS Issue Final Tax Regulations for LIBOR Replacement Amendments - Finance and Banking

Background

The Final Regulations maintain the fundamental principles of the
Proposed Regulations released on October 8, 2019, discussed here, governing avoidance of tax realization
events in connection with Replacement Index Amendments, but include
several structural changes to the Proposed Regulations. These
changes include, most notably, replacing the requirement that the
modified debt instrument or derivative contract result in a
substantially equivalent fair market value in order to avoid a tax
realization event with descriptions of certain specific
modifications that could trigger a tax realization event.

Highlights

  • The Alternative Reference Rates Committee (ARRC) was convened by
    the Board of Governors of the Federal Reserve System and the
    Federal Reserve Bank of New York to identify alternative reference
    rates that would be more reliable than USD LIBOR and to develop a
    plan to facilitate the voluntary acceptance of the alternative
    reference rate or rates that were identified. The Secured Overnight
    Financing Rate (SOFR) was selected by ARRC as the preferred
    replacement for USD LIBOR and the Federal Reserve Bank of New York
    began publishing SOFR daily as of April 3, 2018.

  • The planned phaseout of LIBOR was announced back in 2017. The
    ICE Benchmark Administration, which administers LIBOR, announced on
    March 5, 2021 that publication of overnight, one-month,
    three-month, six-month and 12-month USD LIBOR would cease
    immediately following publication of such interest rates on June
    30, 2023 and that publication of all other currency and tenor
    variants would cease immediately following publication on December
    31, 2021.

Amendments to existing contracts that modify the interest rate
or interest rate-setting mechanism may cause a deemed exchange, for
tax purposes, of the pre-amendment debt for the post-amendment
debt, also known as a reissuance. Such a deemed exchange or
reissuance triggers a realization of gain or loss on the
pre-amendment debt to the applicable holder, and, in the case of
tax-exempt debt, may cause loss of tax-exemption of interest
received on the amended debt unless the amended debt can be issued
as tax-exempt debt and all necessary conditions to the issuance of
such amended debt on a tax-exempt basis are satisfied. Without the
Final Regulations, many Replacement Index Amendments would either
trigger a reissuance or create uncertainty as to whether a
reissuance has occurred, either of which could be costly and
disruptive to holders and issuers of such debt and to the variable
rate debt market in general.

On or before the date on which the applicable LIBOR rates cease
to be published, most existing debt and derivative contracts that
reference LIBOR in setting a variable interest rate will need to be
amended to provide for alternative rate setting mechanisms, as the
typical alternative rate-setting provisions in such contracts
address temporary unavailability of a published LIBOR rate but not
its permanent cessation. These necessary amendments may include the
replacement of a LIBOR-based rate that is in effect with a
substitute rate or rate setting mechanism, and may also include the
addition or replacement of LIBOR-based fallback rates to rates
currently in effect under the applicable contract.

Final Regulations

The preamble to the Final Regulations provides that they are
intended to “help facilitate the economy’s adaptation to
the cessation of LIBOR in a least-cost manner.” The Final
Regulations simplify many of the rules in the Proposed Regulations
through streamlined defined terms and elimination of the proposed
fair market value rule. The Final Regulations should provide more
clarity as to the types of Replacement Index Amendments that would
and would not qualify for special treatment in determining whether
a tax realization event has occurred.

Covered Modifications Under the Final Regulations, a covered
modification to a contract will not be treated as a
modification resulting in the realization of income, deduction,
gain, or loss for purposes of section 1001 of the Internal Revenue
Code (the section that governs when a debt has been sufficiently
modified to trigger a deemed exchange or reissuance for tax
purposes.) This will be true regardless of the form that the
covered modification takes, including express agreement (oral or
written), conduct of the parties or otherwise.

A “covered modification” is a
modification or portion of a modification that (a) replaces an
operative rate that references a discontinued IBOR with a
“qualified rate,” adds an obligation for one party to
make a qualified one-time payment, if the parties so choose, and
makes any associated modifications, and/or (b) in the case of an
operative rate that references a discontinued IBOR, adds a
“qualified rate” as a fallback to such discontinued IBOR,
and makes any associated modifications, and/or (c) replaces a
fallback rate that references a discontinued IBOR with a
“qualified rate,” and makes any associated
modifications. A “discontinued IBOR” is any IBOR
during the period beginning on the date the administrator of the
IBOR or a regulator announces that the administrator has ceased or
will cease to provide the IBOR permanently or indefinitely, and no
successor administrator is expected to continue to provide the
IBOR, and ending on the date that is one year after the date on
which the administrator of the interbank offered rate ceases to
provide the IBOR. Accordingly, the overnight, one-month,
three-month, six-month and 12-month USD LIBOR tenors should be
treated as discontinued IBORs from March 5, 2021 through June 30,
2024. The stated purpose of this time limit is to better tailor the
relief to the problem the Final Regulations are intended to address
– the facilitation of the transition away from discontinued IBORs
without market disruption.

A “qualified rate” includes any
qualified floating rate as defined in section 1.1275-5(b) of the
Internal Revenue regulations (such as SOFR and certain rates of
other jurisdictions associated with their respective currencies),
but without regard to the limitations on multiples set forth
therein, rates selected by certain regulatory authorities as
replacement rates for a discontinued IBOR in their jurisdictions, a
rate selected by ARRC (provided that the Federal Reserve Bank of
New York is an ex officio member of ARRC at the time of selection),
any rate that is determined by reference to a qualified rate
(including a rate determined by adding or subtracting a specified
number of basis points to or from the rate or by multiplying the
rate by a specified number), or any other rate identified as a
qualified rate in future guidance published in the Internal Revenue
Bulletin. The replacement rate must be in the same currency as the
discontinued IBOR or be otherwise reasonably expected to measure
contemporaneous variations in the cost of newly borrowed funds in
the same currency. A single qualified rate may be comprised of one or more fallback
rates, provided that the rate is a qualified rate only if each
individual fallback rate separately satisfies the requirements to
be a qualified rate. If it is not possible to determine at the time
of the modification being tested as a covered modification whether
a fallback rate is a qualified rate (for example, the fallback rate
will not be determined until the fallback rate is triggered based
on factors that are not guaranteed to result in a qualified rate),
the fallback rate is treated as not satisfying the requirements to
be a qualified rate unless the likelihood that any value will ever
be determined under the contract by reference to such fallback rate
is remote.

As stated in the definition, the qualified one-time payment can
compensate for “all or part” of the basis difference
between the discontinued index and the replacement index. The
definition of “qualified rate” includes a rate determined
by adding or subtracting a specified number of basis points to or
from the rate or by multiplying the rate by a specified number.
Accordingly, the regulations give the parties to a debt or
derivative instrument with a LIBOR-based rate mechanism (which may
include basis point add-ons to the specified LIBOR rate and/or a
percentage multiplier to the specified LIBOR rate) the option, in
connection with a change to a permitted new reference rate, to
adjust the prior basis point add-on and/or percentage multiplier,
to make a qualified one-time payment, and/or to use a combination
of such techniques for the purpose of achieving rough equivalence
in the financing cost under the replaced and replacement rate
mechanisms. Noncovered Modifications

A “qualified one-time payment” is a
single cash payment that is intended to compensate the payee for
all or part of the basis difference between the discontinued IBOR
and the interest rate benchmark to which the qualified rate refers.
The Treasury Department and the IRS are still considering how to
address questions with respect to the treatment of a one-time
payment for purposes of the arbitrage investment restrictions and
private use restrictions applicable to tax-advantaged bonds. Until
additional guidance is published, the Final Regulations allow for
reliance on the Proposed Regulations, which provided that the
character and source of a one-time payment made by a given payor is
the same as the source and character of a payment under the
contract by that payor. Presumably, this means that a one-time
payment received by a holder of tax-exempt bonds will generally be
treated as additional tax-exempt interest and, arguably, a one-time
payment received by an issuer of bonds would be treated as reducing
the interest paid, or to be paid, by the issuer, rather than as
additional proceeds. An “associated modification” is the
modification of any technical, administrative or operational term
of a contract that is reasonably necessary to adopt or to implement
a covered modification. Examples include a change to the definition
of interest period and a change to the timing and frequency of
determining rates and making payments of interest.