The IRS issued proposed regulations (REG-118784-18
) on Oct. 8 that provide guidance for taxpayers required to change interest rate benchmarks due to the planned phase-out of interbank offered rates (IBORs), such as the London Interbank Offered Rate (LIBOR), in debt instruments and financial instruments. This issue may affect a significant amount of companies because an abundant amount of debt agreements and derivatives currently reference an IBOR rate.
The proposed regulations address the tax consequences that result from replacing IBORs with other specified reference rates in existing agreements. Significantly, they provide rules and requirements for when an alteration of the terms of an existing agreement (both debt instruments and non-debt contracts) will not result in an exchange of such instruments under Section 1001.
While the proposed regulations were intended to offer transition relief, they may present some significant tax considerations with complexity. Taxpayers should begin considering the impact of potential replacement rates under the new rules. They should also pay close attention to the possible consequences of altering a debt instrument or non-debt contract that is not covered by the proposed rules, but is made contemporaneously with an alternation that is covered by the proposed regulations. The proposed rules are generally not effective until final, but taxpayers may adopt certain rules early.
On July 27, 2017, the U.K Financial Conduct Authority announced that LIBOR, including the U.S. dollar-based LIBOR (USD LIBOR), may be phased out after the end of 2021. The Board of Governors of the Federal Reserve and the Federal Reserve Bank of New York subsequently convened the Alternative Reference Rates Committee (the ARRC) to identify the reference rate to replace the USD LIBOR. On March 5, 2018, the ARRC published a report in support of its selection of the Secured Overnight Financing Rate (SOFR) as the replacement. In connection with the transition, parties will need to modify both new and existing debt instruments and other financial instruments that have an IBOR rate.
Currently, a broad range of financial transactions reference IBORs, including over-the-counter and exchange-traded derivatives, loans, taxable and tax-exempt bonds, floating-rate notes, and securitized products. The ARRC estimated that $200 trillion of outstanding contracts reference USD LIBOR, and that the notional size of derivatives accounted for approximately 95% of the outstanding gross notional value of financial instruments that reference USD LIBOR. According to the ARRC, USD LIBOR is also referenced in several trillion dollars of corporate loans, floating-rate mortgages, floating rate notes, and securitized products.
On April 8, 2019, and June 5, 2019, the ARRC submitted letters to the Treasury Department and the IRS, which identified a number of potential tax issues associated with the elimination of interbank offered rates and requested guidance.
The rules in Prop. Reg. Sec. 1.1001-6(a) generally provide that an alteration of the terms of a debt instrument, or other contract (a non-debt contract), to replace an IBOR rate with a specified “qualified rate” is not treated as a modification for purposes of Section 1001.
An “associated alteration” (or associated modification) is also not treated as a modification for purposes of Section 1001. An associated alteration is defined as an alteration that is: (i) associated with the replacement of the IBOR rate; and (ii) reasonably necessary to adopt or implement that replacement. An associated alteration may be a technical, administrative, or operational alteration or modification, such as a change to the definition of an interest period or a change to the timing and frequency of determining rates and making payments of interest. An associated alteration may also be the addition of an obligation for one party to make a one-time payment in connection with the replacement of the IBOR rate with a qualified rate to offset the change in value of the debt instrument that results from that replacement.
Similarly, an alteration of the terms of a debt instrument, or a non-debt contract, to include a qualified rate as a fallback to an IBOR rate, or to substitute a qualified rate for an IBOR rate as a fallback, is not treated as a modification for purposes of Section 1001. Any associated alterations to the inclusion of a fallback rate are likewise not treated as modifications for purposes of Section 1001.
The tax consequences of an alteration that is not covered by the proposed regulations, but made contemporaneously with an alteration covered by the proposed regulations, are still determined under Treas. Reg. Sec. 1.1001-3 (for debt instruments) and Treas. Reg. Sec. 1.1001-1 (for non-debt contracts). For example, if the parties to a debt instrument change the interest rate to account for deterioration of the issuer’s credit since the issue date, the qualified rate is treated as a term of the instrument prior to the alteration and only the addition of the risk premium is analyzed under Treas. Reg. Sec. 1.1001-3.
The IRS intends that the proposed regulations apply to both the issuer and holder of a debt instrument, and to each party of a non-debt contract, consistent with other regulations under Section 1001. The proposed rules also apply regardless of whether the alteration or modification occurs by an amendment to the terms of the debt instrument or non-debt contract or by an exchange of a new debt instrument or non-debt contract for the existing one.
The proposed regulations apply to both debt instruments and non-debt contracts. A derivative contract is the principal example of a non-debt contract for purposes of the proposed regulations, but the category is also intended to include any other type of contract (e.g. a lease) that may refer to an IBOR and that is not debt. Thus, for example, if an interest rate swap is modified to change the floating rate leg of the swap from USD LIBOR plus 25 basis points to a qualified rate under the proposed regulations, that modification would not be treated as an exchange of property for other property differing materially in kind or extent and would therefore not be an event that results in the realization of income, deduction, gain or loss under Treas. Reg. Sec. 1.1001-1(a).
The proposed regulations list the rates that may be qualified rates provided that they satisfy other requirements. The list of potential qualified rates in Prop. Reg. Sec. 1.1001-6(b)(1) includes:
- SOFR (defined above) published by the Federal Reserve Bank of New York; the Sterling Overnight Index Average
- Tokyo Overnight Average Rate
- Swiss Average Rate Overnight
- Canadian Overnight Repo Rate Average
- Hong Kong Dollar Overnight Index
- The interbank overnight cash rate administered by the Reserve Bank of Australia
- The Euro short-term rate administered by the European Central Bank
- Any alternative, substitute or successor rate selected, endorsed or recommended by the central bank, reserve bank, monetary authority or similar institution (including any committee or working group thereof) as a replacement for an IBOR or its local currency equivalent in that jurisdiction
- Any qualified floating rate as defined in Treas. Reg. § 1.1275-5(b) (but without regard to certain limitations set forth therein), that is not described in the proposed regulations
- Any rate that is determined by reference to a listed 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
- Any other rate identified as a qualified rate by the Treasury and IRS
The proposed regulations also provide that 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. This requirement may be satisfied by one of two safe harbors in the proposed regulations. The first safe harbor is satisfied if the historic average of the relevant IBOR rate does not differ by more than 25 basis points from the historic average of the replacement rate. The second safe harbor is satisfied if the parties to the debt instrument or non-debt contract are not related and determine that the fair market value before the alteration is substantially equivalent to the fair market value after the alteration.
Integrated transactions and hedges
A debt instrument and one or more hedges may be treated in certain circumstances as a single, integrated instrument for certain purposes. Specifically, Treas. Reg. Sec. 1.1275-6 describes circumstances in which a debt instrument may be integrated with a hedge for the purposes of determining the amount and timing of the taxpayer’s income, deduction, gain or loss.
Treas. Reg. Sec.1.988-5 provides that a debt and a hedge may be integrated for purposes of foreign currency transactions, and Treas. Reg. Sec. 1.148-3(h) provides rules related to arbitrage investment restrictions on tax-exempt bonds issued by State and local governments. Under the proposed regulations, an alteration of the terms of a debt instrument or a hedge to replace an IBOR rate with a qualified rate is not treated as a legging out, or termination, as long as the hedge as modified continues to meet the requirements under Treas. Reg. Sec. 1.1275-6, 1.988-5, or 1.148-4(h) respectively.
Timing rules under Treas. Reg. Sec. 1.446-4 provide that the accounting method used by a taxpayer for a hedging transaction must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the income, deduction, gain, or loss from the hedged item. There are special rules under Treas. Reg. Sec, 1.446-4(e)(6) if a taxpayer hedges an item and later terminates the item but keeps the hedge, which provide that the taxpayer must match the built-in gain or loss on the hedge to the gain or loss on the terminated item. The proposed regulations also provide that altering the terms of a debt instrument or a hedging transaction to replace an IBOR rate with a qualified rate on one or more legs of the transaction is not a disposition or termination of either leg under Treas. Reg. Sec. 1.446-4(e)(6).
Source and character of a one-time payment
When parties alter the terms of a debt instrument or modify the terms of a non-debt contract to replace an IBOR rate, the alteration or modification may also include an adjustment to the existing spread to account for the differences between the IBOR rate and the new reference rate. In lieu of an adjustment to the spread, the parties may agree to a one-time payment as compensation for any reduction in payments attributable to the differences between the IBOR rate and the new reference rate.
The proposed regulations provide that the source and character of a one-time payment that is made by a payor in connection with an alteration or modification will be the same as the source and character that would otherwise apply to a payment made by the payor with respect to the debt instrument or non-debt contract that is altered or modified.
and the new reference rate.
Grandfathered debt instruments and non-debt contracts
The requirements of certain statutes and regulations do not apply to certain debt instruments and non-debt contracts issued before a specific date. For example, an obligation issued on or before March 18, 2012, is not a registration-required obligation under Section 163(f) if the obligation was issued under certain arrangements.
The proposed regulations generally prevent debt instruments and non-debt contracts from being treated as reissued following a deemed exchange under Section 1001. Thus, for example, a debt instrument grandfathered under Sections 163(f), 871(m), or 1471, or a regulation thereunder, would not lose its grandfathered status under the proposed regulations. Similarly, the proposed regulations provide that any modification of a non-debt contract to which Prop. Reg. Secs, 1.1001-6(a)(2) or (3) apply is not a material modification for purposes of Treas. Reg. Sec, 1.1471-2(b)(2)(iv).
Original issue discount (OID) and qualified floating rate
The proposed regulations provide three special rules for determining the amount and accrual of OID in the case of a Variable Rate Debt Instrument (a VRDI) that calls for interest at both an IBOR rate and for a fallback rate that is triggered when the IBOR becomes unavailable or unreliable.
First, Prop. Reg. Sec. 1.1275-2(m)(2) provides that the IBOR rate and the fallback rate are treated as a single qualified floating rate for purposes of Treas. Reg. Sec. 1.1275-5. Second, Prop. Reg. § 1.1275-2(m)(3) provides that the possibility that the relevant IBOR will become unavailable or unreliable is treated as a remote contingency for purposes of Treas. Reg. Sec. 1.1275-2(h). Finally, Prop. Reg. Sec. 1.1275-2(m)(4) provides that the occurrence of the event that triggers activation of the fallback rate is not treated as a change in circumstances.
With the exception of these three rules under Prop. Reg. Sec. 1.1275-2(m), the OID regulations apply to an IBOR rate VRDI in the same manner that they would to other debt instruments.
Real Estate Mortgage Investment Conduits (REMICs)
Section 860G(a)(1) provides that a regular interest in a REMIC must be issued on the startup day with fixed terms. Pursuant to Treas. Reg. Sec. 1.860G-1(a)(4), a regular interest has fixed terms on the startup day if, on the startup day, the REMIC’s organization documents irrevocably specify, among other things, the interest rate or rates used to compute any interest payments on the regular interest. Thus, an alteration of the terms of the regular interest to change the rate or fallback provisions in anticipation of the phase-out of an IBOR could preclude an interest in a REMIC from constituting a regular interest.
The proposed regulations would permit an interest in a REMIC to retain its status as a regular interest despite certain alterations and contingencies. Specifically, if the parties to a regular interest alter the terms after the startup day in a manner that is not treated as an exchange under the Prop. Reg. Sec. 1.1001-6, the proposed regulations provide that the alterations are disregarded for the purpose of determining whether the regular interest has fixed terms on the startup day.
In addition, an interest in a REMIC would not fail to be a regular interest solely because the terms of the interest permit the rate to change from an IBOR rate to a fallback rate in anticipation of the relevant IBOR becoming unavailable or unreliable. However, both the IBOR rate and the fallback rate considered individually must be rates permitted under Section 860G.
Finally, an interest in a REMIC would not fail to be a regular interest solely because the amount of payments of principal or interest may be reduced by reasonable costs of replacing an IBOR rate with a qualified rate, amending fallback provisions to address the elimination of an IBOR, or modifying a non-debt contract that is associated with the interest in the REMIC. The proposed regulation also provide that if a party other than the REMIC pays reasonable costs after the startup day, the payment is not subject to the tax imposed under Section 860G(d).
Interest expense of a foreign corporation
Because the election provided in Treas. Reg. Sec. 1.882-5(d)(5)(ii)(B) only permits a foreign corporation that is a bank to elect a rate that references 30-day LIBOR, the current election will not be available when LIBOR is phased out. Thus, the proposed regulations amend the election 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.
The proposed regulations are generally not effective until final regulations are published in the Federal Register. However, Taxpayers and their related parties may apply Prop. Reg. Sec. 1.1001-6 (related to alterations of debt and non-debt) before the final regulations are issued if the taxpayer and related parties consistently apply the rules.
A taxpayer may apply Prop. Reg. Secs. 1.1275-2(m) (related to Variable Rate Debt Instruments) and 1.860G-1(e)(3) (related to contingencies of rate on a regular interest) for any debt instrument or regular interest in a REMIC issued before the date of final regulations. Prop. Reg. Secs.1.860G-1(e)(2) (related to a change in reference rate of a regular interest) and (4) (related to reasonable expenses incurred to alter a regular interest) may be applied for an alteration or modification that occurs before the date of final regulations. Prop. Reg. § 1.882-5(d)(5)(ii)(B) (related to interest expense of a foreign corporation) may be applied for any taxable year ending after Oct. 9, 2019, but before the date of final regulations.
Notwithstanding the taxpayer relief provided in the proposed regulations for the transition from IBORs, there will be significant tax considerations if the proposed regulations are finalized in current form. Taxpayers should understand that they will need to determine whether a replacement rate constitutes a qualified rate and meets the fair market value requirement. They will also need to consider the tax consequences and significant complexity that could emerge if an alteration is not covered by the proposed regulations but is made contemporaneously with an alteration covered by the proposed regulations.
The IRS has requested comments on the proposed regulations by Nov. 25, 2019.
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