January 05, 2022
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On December 30, 2021, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (IRS) released a pre-publication version of final regulations (Treas. Reg. § 1.1001-6) addressing the principal tax consequences related to the planned elimination of interbank offered rates (the “Final Regulations”). The Final Regulations generally follow proposed regulations issued on October 9, 2019 (the “Proposed Regulations”) and Revenue Procedure 2020-44 issued on October 12, 2020 (the “Revenue Procedure”) in providing that certain modifications of debt instruments, derivatives and other contracts implementing a change from an interbank offered rate (IBOR), such as the London Interbank Offered Rate (LIBOR), to another qualified rate will not cause a taxable event for holders, issuers or counterparties.
The Final Regulations reflect two important changes from the Proposed Regulations: (i) the complex substantially equivalent fair market value test of the Proposed Regulations has been eliminated in favor of rules that enumerate certain modifications that are excluded from tax-free treatment, and (ii) a single standard has been adopted for all contracts, instead of separate rules for debt instruments and non-debt instruments. In addition, the Final Regulations contain helpful examples to illustrate the application of such rules.
In 2017, the U.K. Financial Conduct Authority announced the planned phase-out of LIBOR. In anticipation of the discontinuation of LIBOR and other IBORs, many countries, including the United States, have identified alternative benchmark rates. The Federal Reserve Board and the New York Fed convened a group of market participants, the Alternative Reference Rates Committee (ARRC), which identified the Secured Overnight Financing Rate (SOFR), a rate that measures the cost of borrowing cash overnight collateralized by Treasury securities, as the preferred benchmark replacement for the United States.
As described in detail in our prior client alert,[1] the Proposed Regulations generally provided that a transition from an IBOR to another replacement rate would not cause a taxable event for holders, issuers or counterparties so long as certain requirements were met, including that the fair market value of the contract after the alteration is substantially equivalent to the fair market value before the alteration. The Revenue Procedure provided further guidance on the modification of a contract to include a provision that provides a mechanism for the contract’s reference rate to change in the future from an IBOR to one or more replacement rates (a fallback provision).
Absent further guidance from the Treasury and IRS, market participants were concerned that certain modifications of debt instruments or other contracts, such as derivatives, to transition from LIBOR to an alternative reference rate could result in the recognition of taxable gain or loss under section 1001.[2]
In addition to potential realization under section 1001, the tax treatment of these modifications can have certain additional consequences, including with respect to hedges, integrated transactions and “real estate mortgage investment conduits” (REMICs), as discussed below.
The Final Regulations generally adopt the fundamental approach taken by the Proposed Regulations, by providing that the transition from an IBOR to a qualified rate (an IBOR-related modification) generally is not a modification for purposes of section 1001. However, the Final Regulations implement this approach in a different manner than the Proposed Regulations, and the Final Regulations contain technical changes that simplify the operative rules of the Proposed Regulations.
Covered Modification. The Final Regulations provide that a “covered modification” of a contract is not treated as an exchange of property for other property differing materially in kind or extent for purposes of Treas. Reg. § 1.1001-1.
A “covered modification” generally occurs where a contract contains an operative rate or fallback provision that references a discontinued IBOR, and such contract is modified to (i) replace the operative rate with a “qualified rate” (and, if necessary, provide for a qualified one-time payment to be made), (ii) include a qualified rate in the fallback provision to an operative rate referencing a discontinued IBOR, or (iii) replace a rate in a fallback provision referencing a discontinued IBOR with a qualified rate. A “covered modification” also includes any modification of a contract described in section 4.02 of the Revenue Procedure (or any supplements published by the Treasury and the IRS), which consist of modifications that incorporate fallback provisions that have been published by ARRC or ISDA.
In the event that a covered modification of a contract is paired with a “noncovered modification,” the Final Regulations provide that only the covered modification will be analyzed under the rules of Treas. Reg. § 1.1001-6 and any component of the modification that consists of a noncovered modification will be analyzed under the existing rules. A “noncovered modification” is any modification or portion of a modification that is not a covered modification.
The Final Regulations adopt a new defined term of “discontinued IBOR,” which is generally an IBOR that will be discontinued, and an IBOR ceases to be a discontinued IBOR a year after the IBOR’s discontinuation. The purpose of this new definition is to better tailor the relief provided in the Final Regulations to the problem that the Final Regulations are intended to address.
Qualified Rate. To be a covered modification, the rate replacing an IBOR must be a “qualified rate.” A qualified rate includes a qualified floating rate under Treas. Reg. § 1.1275-5(b) (such as SOFR, the Sterling Overnight Index Average, the Tokyo Overnight Average Rate, the Swiss Average Rate Overnight, and the Euro short-term rate administered by the European Central Bank). A qualified rate may also include rates selected by certain regulatory authorities, a rate selected by ARRC (so long as the Federal Reserve Bank of New York continues to be an ex officio member of ARRC), rates determined by reference to a qualified rate, and rates identified in guidance published in the Internal Revenue Bulletin. The qualified rate used to replace an IBOR with respect to a particular contract must be based on transactions conducted in the same currency or reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency.
To clarify how the definition of “qualified rate” applies when a contract is modified to include a waterfall of fallback rates, the Final Regulations provide that a single qualified rate may be comprised of more than one fallback rate, such as a waterfall. Thus, a waterfall where each tier is structured to replace the prior tier upon a trigger event (e.g., where such prior tier is discontinued) may be treated as a fallback to a discontinued IBOR (even though only one tier is actually a fallback to a discontinued IBOR). However, where a waterfall is structured as such, the collection of fallback rates is only treated as a qualified rate if each component rate is itself a qualified rate. The Final Regulations further provide that a fallback rate is not treated as a qualified rate if the terms of the fallback rate do not ensure at the time of the modification that the fallback rate will be properly treated as a qualified rate when such rate is triggered. For these purposes, a fallback rate will be treated as meeting the requirements to be a qualified rate if the likelihood that any value will ever be determined under the contract by reference to the fallback rate is remote.
Excluded Modifications. In response to extensive public comments criticizing the complexity of the substantially equivalent fair market value test, the Treasury and IRS replaced that requirement of the Proposed Regulations with rules detailing “excluded modifications” in the Final Regulations.
A modification is treated as an excluded modification (and thus a noncovered modification) if it changes the amount or timing of contractual cash flows and is (i) intended to induce one or more parties to perform any act necessary to consent to the modification, (ii) intended to compensate one or more parties for a modification other than a covered modification, (iii) either a concession granted to a party to the contract because that party is experiencing financial difficulty or a concession secured by a party to the contract to account for the credit deterioration of another party to the contract, (iv) intended to compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified, or (v) is identified by IRS guidance as having a principal purpose of achieving a result that is unreasonable in light of the purpose of the Final Regulations.
With respect to (v) above, the preamble to the Final Regulations (the “Preamble”) states that it is anticipated that such guidance will be prospective in effect.
Excluded modifications represent noncovered modifications that must be tested under general tax principles to determine whether they give rise to a taxable event.
The Final Regulations do not provide any guidance on the source and character of a one-time payment that is made in connection with an IBOR-related modification. According to the Preamble, in light of the uncertainty generated by the Proposed Regulations, the Treasury and IRS continue to consider whether to adopt further rules to address one-time payments.
The Final Regulations provide that a covered modification that relates to one or more legs of a transaction that is integrated under Treas. Reg. § 1.988-5 (integration of a nonfunctional currency debt instrument and a hedge) or Treas. Reg. § 1.1275-6 (integration of a qualifying debt instrument and a hedge) will not be treated as a “legging out” of the integrated instrument so long as the applicable hedge as modified continues to meet the requirements of the relevant integration regime. The Final Regulations introduce a 90-day grace period during which a covered modification of a component of an integrated transaction does not result in a legging out of the transaction, notwithstanding any mismatch in timing or amount of payments that result from the covered modification.
The Final Regulations also introduce a new rule to address temporary hedges that a taxpayer may enter into to manage any risk resulting from temporary mismatches between the terms of the component parts of an integrated transaction. During the 90-day grace period provided under this new rule, the temporary hedge may be integrated with the other components of the integrated transaction without disruption. Moreover, termination of the temporary hedge within the 90-day grace period is not treated as a legging out of the existing integrated transaction.
In addition, the Final Regulations adopt the approach of the Proposed Regulations that a covered modification of one or more legs of a transaction subject to hedge accounting under Treas. Reg. § 1.446-4 will not be treated as a disposition or termination of either leg of the transaction.
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 such an investment trust constitute a power to vary the investment of any certificate holder of such trust.
The Final Regulations adopt the three rules provided by the Proposed Regulations with respect to REMIC regular interests. First, an alteration that is described in Treas. Reg. § 1.1001-6(a)(1) or (3) of regular interests issued by a REMIC will be disregarded for purposes of the “startup day” rule. Second, an interest in a REMIC will not fail to qualify as a regular interest solely because it is subject to a contingency with respect to a change in the rate in anticipation of an IBOR becoming unavailable or unreliable. Finally, an interest in a REMIC will not fail to qualify as a regular interest solely because it is subject to a contingency with respect to a reduction for reasonable costs incurred to effect an alteration or modification described in the section 1001 rules (described above).
In addition, any payment by a party other than the REMIC of expenses reasonably incurred in connection with any such alteration or modification will not be treated as a contribution for purposes of the 100 percent tax under section 860G(d) for contributions after the startup day. Moreover, the Treasury and IRS noted in the Preamble that they expect costs of obtaining tax opinions and rating agency confirmations in connection with a modification to be reasonable costs within the meaning of Treas. Reg. § 1.860G-1(e)(4).
The Final Regulations include rules applicable to a variable rate debt instrument (VRDI) that provides both for a qualifying floating rate that references a discontinued IBOR and for a methodology to change that rate referencing a discontinued IBOR to a different rate in anticipation of the discontinued IBOR becoming unavailable or unreliable. For such VRDIs, (i) the rate referencing a discontinued IBOR and the different rate are treated as a single qualified floating rate for purposes of the VRDI regulations, (ii) the possibility that the discontinued IBOR will become unavailable or unreliable is treated as a remote contingency, and (iii) the fact that the discontinued IBOR has become unavailable or unreliable is not treated as a change in circumstances.
Under Treas. Reg. § 1.882-5(d)(5)(ii)(B), a foreign corporation that is a bank is permitted to elect a rate that references 30-day LIBOR when determining the interest expense attributable to excess U.S.-connected liabilities in computing the interest expense allocable to income effectively connected with a U.S. trade or business. The Proposed Regulations provided that taxpayers that are banks may elect to use the yearly average of SOFR in place of 30-day LIBOR in such instance without the consent of the IRS. The Preamble notes that the Treasury and IRS are continuing to study what may constitute an appropriate replacement rate, but will permit taxpayers to continue to rely on the rules from the Proposed Regulations and anticipate issuing additional guidance before 30-day USD LIBOR is discontinued in 2023.
The Treasury Department and the IRS stated in the Preamble that they will not treat a change from a discount rate that is based on a discontinued IBOR to a discount rate that is 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 under section 446(e).
A covered modification of a contract is not a material modification of that contract for purposes of the FATCA grandfathering rule.
In response to public comment that a covered modification of preferred stock could cause such stock to be treated as fast-pay stock, the Final Regulations have introduced a rule providing that a covered modification of stock is not a significant modification of the terms of the stock or the related agreements, and it is not a significant change in the relevant facts and circumstances for purposes of Treas. Reg. § 1.7701(l)-3(b)(2)(ii). However, if a covered modification and noncovered modification occur at the same time or as part of the same plan and the noncovered modification is a significant modification of the terms of the stock or the related or agreements or a significant change in the relevant facts and circumstances, then all of the facts and circumstances (including both the covered modification and noncovered modification) are taken into account in determining whether the stock is fast-pay stock.
The Final Regulations largely adopt the approach of the Proposed Regulations and Revenue Procedure providing that, in most cases, an alteration or modification related to a change from an IBOR rate to a new qualified rate will not be a taxable event. The Final Regulations generally are effective for modifications, alterations and issuances that occur on or after March 7, 2022. Taxpayers may choose to rely on the Final Regulations prior to that date provided the taxpayer and all related parties apply the Final Regulations to modifications that occur before that date.
Please contact any member of the Shearman & Sterling LLP tax team for further information.
[1] Shearman & Sterling LLP, Treasury and the IRS Release Tax Guidance on the Transition from Interbank Offered Rates, Oct. 8, 2019
[2] Unless otherwise indicated, all “section” references are to sections of the Internal Revenue Code of 1986, as amended.
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