[co-author: Ishani Kundu, Law Clerk]
On October 9, 2019, the U.S. Department of the Treasury and the Internal Revenue Service proposed regulations (“Proposed Regulations”) addressing the transition from London interbank offered rate (“LIBOR”) to the use of reference rates other than interbank office rates (“IBOR”) in debt instruments and certain non-debt contracts. LIBOR and its currency and term variants are expected to be phased out by the end of 2021. The Proposed Regulations would amend the tax law in the following ways:
Certain Alterations Not Deemed Exchanges: Under the Proposed Regulations, certain alterations of the terms of a debt instrument would not be considered modifications and would not result in deemed exchanges under Treasury Regulations section 1.1001-3. Specifically, replacing a rate referencing an IBOR with a “qualified rate” (“Qualified Rate”) as defined under the Proposed Regulations, including a Qualified Rate as a fallback to an IBOR, or substituting a Qualified Rate for a rate referencing an IBOR as a fallback to another rate would not result in a deemed exchange.
A Qualified Rate would include (i) one of eight enumerated reference rates, including the Secured Overnight Financing Rate (SOFR) and the Sterling Overnight Index Average (SONIA); (ii) any alternative, substitute or successor rate selected, endorsed or recommended by certain authorities as a successor to an IBOR; (iii) any other “qualified floating rate” as defined under Treasury Regulations; (iv) any rate determined by reference to one of the above rates, including a rate determined by adding or subtracting a specified number of basis points or multiplying by a specified number; or (v) any rate specified by the IRS.
A rate is a Qualified Rate only if the fair market value of the debt instrument or non-debt contract after the relevant alteration or modification is substantially equivalent to the fair market value before that alteration or modification. 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 requirement is satisfied if at the time of the alteration the historic average of the IBOR-referencing rate is within twenty-five basis points of the historic average of the rate that replaces it. The parties may use any reasonable method to compute an historic average, subject to two limitations. First, the lookback period from which the historic data are drawn must begin no earlier than ten years before the alteration or modification and end no earlier than three months before the alteration or modification. Second, once a lookback period is established, the historic average must take into account every instance of the relevant rate published during that period. Alternatively, the parties may compute the historic average of a rate in accordance with an industry-wide standard. Under the second safe harbor, the value equivalence requirement is satisfied if 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 the altered debt instrument or modified non-debt contract is substantially equivalent to the fair market value before the alteration.
An “associated alteration” with respect to any of the above alterations would not be considered a modification of the underlying debt instrument, including any alteration reasonably necessary to adopt or implement one of the above alterations and a one-time payment made by one of the loan parties in connection with one of the above alterations. The source and character of such one-time payment is the same as the source and character that would otherwise apply to a payment made by that payor under the debt instrument or non-debt contract.
A modification to a debt instrument that is contemporaneous with one of the above alterations would need to be analyzed under the general “significant modification” rules pursuant to Treasury Regulations section 1.1001-3. However, the pre-modification loan would be considered to include the terms of the alteration for purposes of the “significant modification” analysis.
The alteration of the terms of a non-debt contract (such as a derivative, stock, insurance contract or lease agreement) to replace a rate referencing an IBOR with a Qualified Rate and any “associated alterations” with respect to such alteration would not be treated as an exchange of property for other property differing materially in kind.
Certain Integrated Transactions and Hedges: The alteration of the terms of a debt instrument or the terms of a derivative, as applicable, to replace an IBOR with a Qualified Rate would not change the tax treatment of certain related integrated transactions or hedges provided in each case that the related transaction continues to qualify under the relevant Treasury regulations after the alteration. Under the Proposed Regulations, the alteration of the terms of (i) a debt instrument or derivative on one or more legs of a transaction integrated under either Treasury Regulations sections 1.988-5 or 1.1275-6 would not be treated as legging out of the transaction; (ii) a debt instrument or derivative on one or more legs of a transaction subject to hedge accounting rules under Treasury Regulations section 1.446-4 would not be treated as a disposition or termination of either leg of such transaction; and (iii) an integrated qualified hedge under Treasury Regulations section 1.148-4(h) will not be treated as a termination for purposes of arbitrage investment restrictions applicable to State and local tax-exempt bonds and other tax-advantaged bonds.
REMIC Regular Interests Will Not Fail To Qualify: An alteration described in section 1.1001-6 of the Proposed Regulations to the terms of a “regular interest” (“Regular Interest”) in a real estate mortgage investment conduit (“REMIC”) after the REMIC’s “startup day” would not cause the Regular Interest to fail to have “fixed terms” on the startup day as required under the Treasury regulations applicable to REMICs. Additionally, a Regular Interest would not fail to qualify as such solely because it is subject to the contingency that it pays interest at a rate that changes from an IBOR-referenced rate to another REMIC qualified rate in anticipation of such IBOR becoming unavailable or unreliable. Finally, under the Proposed Regulations a Regular Interest would not fail to qualify as such solely because the payment of principal or interest (or other similar amount) with respect to such Regular Interest is reduced by reasonable costs incurred to effect one of the alterations described above.
Treatment as a Single Variable Rate: A variable rate debt instrument (“VRDI”) that provides for both a qualified floating rate referencing an IBOR and a methodology to change to a different rate in anticipation of the IBOR becoming unavailable or unreliable would be treated as having a single “qualified floating rate” for purposes of the determining original issue discount (“OID”) with respect to a VRDI. Furthermore, the possibility that the IBOR will become unavailable or unreliable is treated as a “remote contingency” that will be disregarded for OID purposes and will not be treated as a “change in circumstances” that might otherwise require the VRDI to be treated as retired and reissued on the alteration date for OID purposes.
Foreign Banks: Foreign corporate banks would be allowed to elect annually to compute their interest expense attributable to U.S.-connected liabilities by using the yearly average SOFR instead of the LIBOR required under current Treasury regulations.
Effective Date: Taxpayers may rely on the following provisions of the Proposed Regulations for the following purposes prior to the date the final Treasury Regulations are published: (i) section 1.1001-6 of the Proposed Regulations for any alteration of the term of a debt instrument or modification of the terms of a non-debt contract, provided that the taxpayer and its related parties consistently apply the rules of section 1.1001-6 of the Proposed Regulations before that date; (ii) sections 1.1275-2(m) and 1.860G-2(e)(3) of the Proposed Regulations for any debt instrument or Regular Interest issued before that date; sections 1.860G-2(e)(2) and 1.860G-2(e)(4) of the Proposed Regulations for any alteration or modification that occurs before that date; and (iii) section 1.882-5(d)(5)(ii)(B) of the Proposed Regulations for any taxable year ending after October 9, 2019 but before the date the final Treasury Regulations are published. Comments on the Proposed Regulations are due by November 25, 2019.
