In light of the discontinuation of LIBOR,1 the U.S. Internal Revenue Service (IRS) and Department of the Treasury published final regulations (Final Regulations) on January 4, 2022, providing guidance on the tax consequences of the discontinuation of LIBOR and certain other interbank offered rates (IBORs). In particular, the guidance relates to whether a modification of a debt instrument to replace a discontinued IBOR with a replacement rate (such as the secured overnight financing rate, or SOFR) results in a taxable exchange. The Final Regulations generally provide that a “covered modification” (discussed below) will not result in a tax realization event. The Final Regulations retain the basic approach of the proposed regulations published on October 8, 2019 (Proposed Regulations), with certain structural revisions to simplify the rules and several technical changes further discussed below. For a description of the Proposed Regulations, see New Proposed Regulations Provide Much-Needed Guidance on U.S. Tax Consequences of Replacing LIBOR and Other Interbank Offered Rates.
The Final Regulations provide that a covered modification of a “contract” (a term that includes a debt instrument, derivative contract, stock, insurance contract and lease agreement) will not result in a tax realization event because (1) it is not treated as an exchange of property for other property differing materially in kind or in extent for purposes of Treasury Regulations Section 1.1001-1(a), and (2) it is not treated as a significant modification for purposes of Treasury Regulations Section 1.1001-3.
A covered modification is generally a modification of the terms of a contract that2
- replaces an operative rate that refers to a “discontinued IBOR” (discussed below) with a “qualified rate” (discussed below) and, if applicable, adds an obligation for one party to make a “qualified one-time payment” (discussed below);
- includes a qualified rate as a fallback to an operative rate that refers to a discontinued IBOR;
- replaces a fallback rate that refers to a discontinued IBOR with a qualified rate;
- includes any associated modifications with respect to those modifications of the operative rate or fallback provisions; or
- is a modification incorporating the recommended ISDA or ARRC fallback provisions described in section 4.02 of Revenue Procedure 2020-44.3
To qualify as a covered modification, a modification cannot be one the listed excluded modifications. The Final Regulations also include as a covered modification an incidental cash payment intended to compensate a counterparty for small valuation differences resulting from a modification of the administrative terms of a contract, such as the valuation differences resulting from a change in observation period.
The Proposed Regulations were silent with respect to whether a modification by which the parties add or amend a fallback provision needs to be tested only at the time of the addition or amendment of the fallback provision or also separately at the time of activation of the fallback provision. In the preamble to the Final Regulations, the IRS clarified that any change to the terms of a contract that results from the activation of a fallback provision must be tested separately at the time of activation as well.4
Final Regulations Are Applicable Only to Discontinued IBORs
The Final Regulations refer to IBORs generally, without naming the specific IBORs for which relief is available. However, the Final Regulations limit the relief to “discontinued IBORs.” Generally, an IBOR is a discontinued IBOR if its administrator has announced that the administrator has or will cease to provide the IBOR. Starting one year after an IBOR's discontinuation, the IBOR will no longer qualify as a discontinued IBOR under the Final Regulations (and thus changes made to an effected contract following the one-year period will not be eligible for relief under the Final Regulations). If an IBOR is published on a “synthetic” basis following the date of its general discontinuation, the one-year period will commence when the “synthetic” IBOR is no longer published (rather than on the earlier general discontinuation date).
The ICE Benchmark Administration announced on March 5, 2021, that publication of overnight, one-month, three-month, six-month, and 12-month USD LIBOR (the Principal USD LIBOR Tenors) will cease immediately following the LIBOR publication on June 30, 2023, and that publication of all other currency and tenor variants of LIBOR will cease immediately following the LIBOR publication on December 31, 2021. Accordingly, IBORs administered by the ICE Benchmark Administration now qualify as discontinued IBORs under the Final Regulations. That qualification (i) is expected to last until at least June 30, 2024, for the Principal USD LIBOR Tenors (assuming they are discontinued as of June 30 2023, as expected) and (ii) until at least December 31, 2022, for the other discontinued IBORs (based on their discontinuation as of December 31, 2021). Those dates will be pushed out to the extent that a discontinued IBOR is published on a “synthetic” basis following its general discontinuation date.5 Parties to affected contracts would have until such dates to modify the contracts (in a manner permitted by the Final Regulations) without such modification’s causing a taxable exchange for U.S. federal income tax purposes.
Removal of Fair Market Value Requirement for a Qualified Rate
Under the Proposed Regulations, a replacement rate had to meet three requirements to be a qualified rate: (i) The replacement rate had to appear on the provided list of eligible rates; (ii) the fair market values of the contract before and after the change had to be substantially equivalent; and (iii) the interest rate benchmark to which the replacement rate referred and the IBOR to which the contract referred had to be based on transactions conducted in the same currency or are otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency.
The IRS received many public comments on the practical and technical issues related to the fair market value requirement and therefore removed it from the Final Regulations. This will make it easier for parties to a contract to determine whether a replacement rate is a qualified rate. Instead, the Final Regulations include a list of excluded modifications that will not constitute “covered modifications.” Such excluded modifications generally include modifications that change the amount or timing of contractual cash flows if the change is (i) made with the intention to (A) induce a party to perform any necessary act to consent to a covered modification, (B) compensate a party for making a noncovered modification or (C) compensate a party for a change in rights or obligations not derived from the modified contract, (ii) a concession granted or secured due to a party’s financial difficulty or credit deterioration or (iii) identified in future IRS guidance.
The Final Regulations expand the list of rates eligible to be qualified rates by including any other type of contract rate identified by the ARRC as a replacement for an IBOR and only for as long as the Federal Reserve Bank of New York continues to be an ex officio member of the ARRC.
The Final Regulations provide that a single qualified rate may be composed of more than one fallback rate, such as when the parties add a fallback waterfall, provided that each individual fallback rate in the group meets the requirements to be a qualified rate. If it is not possible to determine whether each fallback rate in a waterfall qualifies as a qualifying rate at the time the modification is being tested, then the fallback waterfall (in its entirety) will fail to satisfy the requirements of a qualified rate. However, if the likelihood of a fallback rate ever being triggered is remote (as determined at the time the modification is being tested), then that fallback rate is treated as satisfying the requirements to be a qualified rate.
Limit on Qualified One-Time Payments
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 interest rate benchmark to which the qualified rate refers. Any portion in excess of that cap is a noncovered modification; therefore, whether the payment of such excess portion is an exchange of property for other property differing materially in kind or in extent is determined under the ordinary rules in Treasury Regulations Section 1.1001-1(a) or Treasury Regulations Section 1.1001-3.
The Treasury Department and the IRS did not provide further guidance on the character and source of qualified one-time payments but stated that they are still considering how to address these issues. Meanwhile, taxpayers may continue to rely on the rule in the Proposed Regulations 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.
No Change to Investment Trust Tax Classification
Under Treasury Regulations Section 301.7701-4(c)(1), an investment trust is not classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. The Final Regulations provide that neither a covered modification of a contract held by an investment trust nor a covered modification of an ownership interest in the investment trust manifests a power to vary the investment of the certificate holder for this purpose, thereby assuring that such modification would not cause the investment trust to lose its classification as a trust for U.S. federal income tax purposes.
REMIC Rules Remain the Same
The Final Regulations follow the rules provided in the Proposed Regulations with respect to real estate mortgage investment conduits (REMICs), meaning that a covered modification or contingent rate change of a discontinued IBOR will not cause a REMIC regular interest to not qualify as such. An interest in a REMIC does not fail to qualify as a regular interest solely because it is subject to a contingency whereby (i) a rate that references a discontinued IBOR and is a variable rate permitted under the REMIC rules may change to a fixed rate or a different variable rate permitted under the REMIC rules in anticipation of the discontinued IBOR becoming unavailable or unreliable or (ii) the amount of payments of principal or interest (or other similar amounts) with respect to the interest in the REMIC is reduced by reasonable costs incurred to effect a covered modification. The costs of obtaining tax opinions and rating agency confirmations are deemed to be reasonable costs for these purposes.
The Final Regulations also state that Treasury Regulations Section 1.860G-1(e) provides rules relating to the modification of the terms of an asset held by a REMIC (i.e., a qualified mortgage), but it is actually silent as to the effect of any such modifications. Presumably, if such modification is a covered modification, it will not result in a taxable event.
Grace Period for Integrated Transactions and Hedging Transactions
The Final Regulations provide a grace period during which a covered modification of a component of a transaction integrated under Treasury Regulations Sections 1.1275-6, 1.988-5(a), or 1.148-4(h) does not result in legging out of that integrated transaction, notwithstanding any mismatch in timing or amount of payments that results from the covered modification during the grace period. The grace period lasts 90 days and starts on the date of the first covered modification of any component of the integrated transaction. However, the covered modification is treated as a legging out as of the date of the covered modification if the hedge component of the integrated transaction does not qualify, by the end of the grace period, as (i) a Treasury Regulations Section 1.1275-6 hedge, (ii) a Treasury Regulations Section 1.988-5(a) hedge or (iii) a qualified hedge under Treasury Regulations Section 1.148-4(h).
Protections Against Fast-Pay Stock Designation
To address the concern that a covered modification of preferred stock could cause the stock to satisfy the definition of fast-pay stock, which could give rise to a “listed transaction,” the Final Regulations provide that a covered modification of stock is not a significant modification in the terms of the stock or the related agreements or a significant change in the relevant facts and circumstances for purposes of Treasury Regulations Section 1.7701(l)-3(b)(2)(ii).
Except as noted below with respect to REMICs, the Final Regulations apply to any modification of the terms of a contract that occurs on or after on March 7, 2022. A taxpayer may choose to apply the Final Regulations to modifications of the terms of contracts that occur before such date, provided that the taxpayer and all its related parties (e.g., subsidiaries and certain affiliates) apply the Final Regulations to all modifications of the terms of contracts that occur before that date. The Final Regulations do not appear to require that all parties to a contract modified prior to the effective date treat the transaction consistently.
The portion of the Final Regulations related to REMICs is effective on March 7, 2022. However, a taxpayer may choose to apply such regulations to modifications that occur before that date or to REMIC regular interests issued before that date.
On December 9, 2021, the House of Representatives passed the Adjustable Interest Rate (LIBOR) Act of 2021 to address contracts with a U.S. dollar LIBOR reference rate (excluding one-week and two-month U.S. dollar LIBOR). The Senate’s proposed version includes tax-related language specifically providing that the following will not be treated as a sale, exchange or other disposition of property for purposes of Section 1001 of the Internal Revenue Code of 1986: (i) the selection or use of a benchmark replacement identified by the Federal Reserve that is based on SOFR, (ii) the determination, implementation or performance of benchmark replacement conforming changes, or (iii) the replacement of LIBOR with a benchmark replacement identified by the Federal Reserve that is based on SOFR. It is unclear what effect, if any, the Final Regulations will have on this legislation (if it is enacted).
1As discussed above, “discontinuation” refers to the cessation of the publication of LIBOR. Thus, for example, it does not refer to the fact that U.S. and UK regulators have stated that after December 31, 2021, no new contracts using U.S. dollar LIBOR should be entered into (though, as a result of those statements, market participants have now discontinued using U.S. dollar LIBOR for many purposes even though it continues to be published).
2Subject to certain exceptions, changes to the terms of a debt instrument that occur pursuant to the original terms of the debt instrument are not considered modifications for purposes of Treasury Regulations Section 1.1001-3 and therefore should not result in a tax realization event.
3On October 9, 2020, the Treasury Department and the IRS released Rev. Proc. 2020-44, 2020-45 I.R.B. 991, to support the adoption of the Alternative Reference Rates Committee’s (ARRC) recommended fallback provisions and the ISDA 2020 IBOR Fallbacks Protocol. Rev. Proc. 2020-44 provides that a modification to incorporate the ARRC fallback provisions or ISDA 2020 IBOR Fallbacks Protocol provisions is not treated as an exchange of property for other property differing materially in kind or extent for purposes of Treasury Regulations Section 1.1001-1(a).
4Despite the need to retest at the time of activation, the mere activation of a fallback provision that replaces LIBOR with a “qualified rate” (without any other changes) would generally constitute a covered modification under Treasury Regulations Section 1.1001-6.
5The preamble to the Final Regulations explains: “[F]or example, three-month sterling LIBOR became a discontinued IBOR on March 5, 2021, the date on which the ICE Benchmark Administration announced that it would permanently cease to publish three-month sterling LIBOR, and will cease to be a discontinued IBOR one year after the date on which the ICE Benchmark Administration ceases to publish the three-month tenor of synthetic GBP LIBOR.” 87 Fed. Reg. 166 (January 4, 2022) at 168 (emphasis added).
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