On December 30, 2021, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released final regulations (the Final Regulations) regarding the tax consequences of certain modifications to debt instruments, derivatives and other contracts as part of the transition away from the London Interbank Offered Rate (LIBOR) and certain other interbank offered rates (IBORs). While making simplifying changes to the operative regulatory language, the Final Regulations generally follow the substantive results proscribed in the proposed regulations issued on October 8, 2019 (the Proposed Regulations) with certain notable changes, including:
- eliminating the fair market value requirement from the Proposed Regulations,
- providing guidance on modifications that add multiple fallback rates, and
- modifying the rules from the Proposed Regulations concerning one-time payments and associated modifications.
The Final Regulations generally provide that a “covered modification” is not treated as an exchange of property for U.S. federal income tax purposes even if such a modification would otherwise be treated as an exchange of property under the generally applicable U.S. federal income tax rules. Thus, the Final Regulations provide certainty with respect to covered modifications even if such modifications arguably would not have resulted in an exchange of property under the generally applicable U.S. federal income tax rules.
A covered modification is limited to certain modifications to contracts referencing a “discontinued IBOR” in connection with transitioning to a “qualified rate.”
- Discontinued IBOR: A discontinued IBOR generally is an IBOR that has ceased, or will have ceased, to be provided, and an IBOR is no longer a discontinued IBOR a year after it has ceased to be provided.
- Qualified Rate: A qualified rate is a rate that is listed in the Final Regulations as eligible to be a qualified rate (such as the Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (SOFR)), so long as it is in the same currency as the discontinued IBOR or is reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency.
A covered modification is further limited to three specific scenarios:
Replacement of a Discontinued IBOR with a Qualified Rate: The replacement of an operative rate that refers to a discontinued IBOR with a qualified rate and, optionally, the addition of an obligation for one party to make a one-time payment to offset the change in value of the contract that results from replacing an IBOR-based rate with a qualified rate, a “qualified one-time payment;”
- Addition of a Qualified Rate Fallback to a Discontinued IBOR: The inclusion of a qualified rate as a fallback to an operative rate that refers to a discontinued IBOR; or
- Replacement of a Discontinued IBOR Fallback with a Qualified Rate Fallback: The replacement of a fallback rate that refers to a discontinued IBOR with a qualified rate.
In each case, a modification of the technical, administrative or operational terms of a contract that is reasonably necessary to adopt or to implement a covered modification is included in the definition of a covered modification.
Finally, the Final Regulations specifically provide that a covered modification includes a modification to incorporate certain Alternative Reference Rates Committee (ARRC) and International Swaps and Derivatives Association (ISDA) fallback language as narrowly described in section 4.02 of Revenue Procedure 2020-44.
Elimination of Fair Market Value Requirement
Perhaps the most consequential change in the Final Regulations is the removal of the fair market value requirement. The Proposed Regulations only provided certainty that a modification would not have resulted in an exchange of property for U.S. federal income tax purposes if the fair market value of the applicable contract was “substantially equivalent” before and after such modification. While the Proposed Regulations provided two safe harbors pursuant to which this requirement would be deemed satisfied, the application of such safe harbors presented both technical and practical difficulties.
The Final Regulations jettison the fair market value requirement and instead create a blacklist of proscribed modifications ineligible for the protection of the Final Regulations. These blacklisted modifications generally address situations where the modification is done for a reason that is unrelated, or only tangentially related, to the transition away from the IBOR (e.g., providing holders of debt who consent to a modification with a higher rate to induce consent) and provide a residual category whereby the IRS can identify additional modifications as having a principal purpose of achieving a result that is unreasonable in light of the purpose of the blacklist.
One-Time Payment Characterization
A covered modification may include a qualified one-time payment to offset the change in value of the contract that results from replacing an IBOR-based rate with a qualified rate. The Final Regulations generally limit a qualified one-time payment to the amount intended to compensate for the basis difference between the discontinued IBOR and the benchmark to which the qualified rate refers.
The Proposed Regulations provided that one-time payments would have the same character that a payment under the instrument would normally have. However, the Proposed Regulations did not clarify how a payment would be characterized in particular situations, including contracts with multiple payments of different character or payments from lenders to borrowers. The IRS and Treasury did not provide further guidance on this issue. While the IRS and Treasury are still considering this issue, taxpayers may continue to rely on the Proposed Regulations.
Incidental Cash Payments as Associated Modifications
The Final Regulations expand upon the definition of associated modification in the Proposed Regulations by including incidental cash payments intended to compensate for small value differences. These incidental payments are separate from and in addition to “qualified one-time payments.”
Qualified Rate Changes
Multiple Fallback Rates. The Final Regulations also expand the definition of qualified rates to address the issue of multiple fallback rates. First, if multiple fallback rates are provided, such as in a waterfall, then the fallback rates as a whole only qualify if each individual rate also qualifies. Second, if it is not possible to determine whether a fallback rate will qualify at the time of modification, then that rate is treated as not qualifying. Finally, a normally invalid fallback rate can qualify if, at the time of modification, the likelihood is remote that any value will ever be determined under the contract by reference to the rate.
Certain Non-Governmentally Recommended Rates. The Proposed Regulations contained a non-exclusive list of rates that are generally “qualified rates” and can be substituted for an IBOR within the protection of the regulations. The IRS and Treasury rejected calls to allow purely private organizations like ISDA to directly expand the list of acceptable substitution rates. Instead, the IRS and Treasury only granted this authority to the ARRC, and only while the Federal Reserve Bank of New York is an ex officio member of that committee.
Interim Non-IBOR Rates. As noted in the preamble, the Final Regulations do not treat a modification to the terms of a contract after an existing fallback provision has replaced all references to an IBOR with another rate as a covered modification. The stated rationale being that such guidance was not necessary to achieve the narrow purpose of facilitating the transition away from the LIBOR and certain other IBORs. Thus, the activation of a fallback provision designed to revert from an available non-IBOR rate to another preferred non-IBOR rate is not a covered modification. Because these provisions typically are designed to revert to Term SOFR (e.g., from Daily Simple SOFR), the ARRC’s recent recommendation of Term SOFR likely alleviates much of the pressure on this point.
Foreign Banks’ Interest Expense
The IRS and Treasury refrained from issuing final guidance on the appropriate rate that foreign banks and their U.S. branches should use to replace 30-day USD LIBOR with respect to calculating interest expense attributable to effectively connected U.S. income. The Proposed Regulations had provided the option to use a yearly average SOFR, but commentators expressed concern that this would not be a fair replacement. The IRS and Treasury anticipate issuing additional guidance about the appropriate replacement rate before 2023, when 30-day USD LIBOR will be discontinued. Until final guidance is issued, taxpayers can use either the general rule in Treas. Reg. § 1.882-5(d)(5)(ii)(A), the annual rate election in Treas. Reg. § 1.882-5(d)(5)(ii)(B) or the yearly average SOFR option in the Proposed Regulations.
Guidance Regarding Hedging and Integrated Transactions
Similar to the Proposed Regulations, the Final Regulations generally provide that a covered modification relating to one of the legs of a hedging transaction under Treas. Reg. § 1.446-4 will not be treated as disposing of or terminating the hedging transaction.
Likewise, under the Final Regulations, a covered modification relating to one of the legs of an integrated transaction under Treas. Reg. § 1.1275-6 or a qualified hedging transaction under Treas. Reg. § 1.988-5 will not be treated as legging out, as long as the arrangement still qualifies for integration immediately after such covered modification or within a 90-day grace period beginning on the date of such covered modification.
The Final Regulations also provide that temporary hedges used to cushion the effect of passing mismatches between the parts of the integrated transaction can be integrated during the 90-day grace period without spoiling the broader integrated transaction.
The Final Regulations provide similar rules for covered modifications relating to a qualified hedge or tax-advantaged bonds with which the qualified hedge is integrated under Treas. Reg. § 1.148-4(h)(1).
Certain Variable Rate Debt Instruments
Consistent with the Proposed Regulations, the Final Regulations provide special rules applicable to variable rate debt instruments under Treas. Reg. § 1.1275-5(a) that reference a discontinued IBOR and provide for a methodology to changing such rate in anticipation of the discontinued IBOR becoming unavailable or unreliable.
- Single Qualified Rate: Such instruments are treated as referencing a single qualified floating rate, thus, avoiding potential original issue discount as a result of referring to two or more qualified floating rates.
- Discontinuation Remote Contingency: The possibility that the referenced discontinued IBOR will become unavailable or unreliable is treated as remote for purposes of Treas. Reg. § 1.1275-2(h), thus, avoiding treatment as a contingent payment debt instrument under Section 1.1275-4(a)(4).
- No Change in Circumstances: The fact that the referenced discontinued IBOR has become unavailable or unreliable is not treated as a change in circumstances under Treas. Reg. § 1.1275-2(h)(6), thus, avoiding retirement and reissuance for original issue discount purposes.
The Final Regulations provide helpful guidance in other areas consistent with a covered modification not being a deemed exchange, including that (i) a REMIC will not fail to qualify as a REMIC, and similarly, a grantor trust will not have an impermissible “power to vary,” solely because of a covered modification and (ii) a covered modification is not considered a “significant modification” for purposes of determining whether stock is “fast-pay stock” under Treas. Reg. § 1.7701(l)-3(b)(2).
Finally, the preamble to the Final Regulations provides that the IRS will not treat a change from a discontinued IBOR to a qualified rate for the purpose of valuing securities under the mark-to-market rules in section 475 as a change in method of accounting requiring consent of the IRS under section 446(e).