Final Treasury regulations published on transition from IBORs to qualified rates
The Internal Revenue Service and the US Treasury Department have issued final regulations providing rules for taxpayers transitioning from interbank offered rates to qualified rates. These regulations provide financial institutions, counterparties, and investors with helpful guidance and clarification of the October 2019 proposed regulations by generally providing that modifications made in accordance with the final regulations will not be considered a taxable event, although certain questions remain unresolved. Most notably, the final regulations remove the fair market value requirement for the replacement rate that was in the proposed regulations, and speak to the consequences of modifications in the context of real estate mortgage investment conduits, investment trusts, and integrated and hedging transactions, among others.
The interbank offered rates (IBORs), such as the London Interbank Offered Rate (LIBOR), set benchmark rates for unsecured lending for various financial instruments. The US-dollar LIBOR (USD LIBOR) is especially prevalent for US financial institutions and is used to set the benchmark across a myriad of financial instruments, including debt instruments and financial contracts. In 2017, the UK Financial Conduct Authority (FCA), the entity that oversees LIBOR, announced that LIBOR, including USD LIBOR, may be phased out at the end of 2021. Subsequently, the FCA and the ICE Benchmark Administration, the administrator of LIBOR, have released several statements generally to the effect that in mid-2023, representative rates for the most frequently used USD LIBOR rates will cease to be available. Due to the winding down of LIBOR-referencing rates, financial institutions and other parties have been identifying alternative reference rates.
Various tax considerations arise in connection with changing a reference rate, as well as associated alterations or modifications. For example, changing a reference rate could constitute a “significant modification” of a debt instrument, therefore resulting in a deemed sale or exchange of that debt instrument under Section 1001 of the Internal Revenue Code of 1986, as amended (the Code) and related Treasury Regulations. Changing a reference rate may also lead to tax consequences under the rules applicable to real estate mortgage investment conduits (REMICs), investment trusts, integrated transactions and hedging transactions, and interest expenses of foreign corporations, among others.
In response to questions regarding these potential consequences, the Internal Revenue Service (IRS) and the US Treasury Department (Treasury) released proposed regulations in October 2019 (Proposed Regulations) and Revenue Procedure 2020-44 in October 2020. The Proposed Regulations and Revenue Procedure 2020-44 were intended to provide interim guidance to facilitate the transition away from IBOR-referencing rates.
Most recently, on December 30, 2021, the IRS and Treasury released final regulations (Final Regulations) providing guidance on the tax consequences related to the transition away from the use of IBOR-referencing rates to different reference rates in debt instruments and financial contracts. The Final Regulations generally adopt and finalize the Proposed Regulations with certain key amendments and generally incorporate the guidance provided in Revenue Procedure 2020-44. The following summary outlines certain key provisions set forth in the Final Regulations.
Covered Modifications Under Section 1001
The Final Regulations provide that a modification of a contract that is a “covered modification” is not treated as an exchange of property under Section 1001 of the Code. A covered modification generally has four elements:
- A contract with an operative rate or fallback provision that references a “discontinued IBOR”
- A “modification” of that contract: (1) to replace an operative rate that refers to a discontinued IBOR with a “qualified rate” or to add an obligation for one party to make a “qualified one-time payment” (if any); (2) to include a qualified rate as a fallback to an operative rate that refers to a discontinued IBOR; or (3) to replace a fallback rate that refers to a discontinued IBOR with a qualified rate
- Any “associated modifications” with respect to those modifications of the operative rate or fallback provisions
- The modification is not an “excluded modification”
A covered modification also includes modifications permitted under Revenue Procedure 2020-44. If a portion of a modification is a covered modification and a portion is a “noncovered modification” (as defined below), the covered modification is treated as part of the terms of the original contract or debt instrument while the noncovered modification is tested for sale or exchange treatment separately under Section 1001 of the Code.
A “discontinued IBOR” is an IBOR that will be discontinued. It ceases to be a discontinued IBOR one year after the discontinuation.
“Modification” is broadly construed to include any modification regardless of form.
A “qualified rate” is a rate that is listed as eligible to be a qualified rate (such as the Secured Overnight Financing Rate, or SOFR), provided that the interest rate benchmark to which the rate refers and the discontinued IBOR are 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 Proposed Regulations required, in the definition of qualified rate, that the fair market value of a contract generally was substantially equivalent before and after the modification and provided two safe harbors. The Final Regulations have removed the fair market value requirement and instead include a list of modifications that are excluded from the definition of covered modification, as further described below.
Many market transactions contemplate the use of a waterfall approach to address the replacement of a discontinued IBOR. Under such a waterfall approach, a tier of fallback rates is listed. The Final Regulations provide that if each individual rate in the waterfall is a qualified rate then the waterfall is a qualified rate.
Under the Final Regulations, a fallback rate is not treated as a qualified rate if it is not possible to determine, at the time of the modification, whether the fallback rate will meet the requirements to be treated as a qualified rate, but such an indeterminable fallback rate is treated as a qualified rate if the likelihood that the fallback rate will ever be triggered is remote.
Qualified One-Time Payments
A “qualified one-time payment” is a payment that results from replacing an IBOR-based rate with a qualified rate to offset the change in value of the affected contract. The Final Regulations provide that a covered modification may include a qualified one-time payment associated with such a replacement, provided that such qualified one-time payment is limited to the amount intended to compensate for the basis difference between the IBOR-referencing rate and the qualified rate, with any amount above such amount treated as a noncovered modification.
An “associated modification” is a modification that is reasonably necessary to adopt or to implement the replacement or inclusion of an IBOR-based rate and includes any incidental cash payment intended to compensate a counterparty for small valuation differences resulting from a modification of the administrative terms of a contract.
The following modifications are excluded from the definition of a covered modification and are therefore “noncovered modifications”: the terms of the contract are modified to change the amount or timing of contractual cash flows and:
- that change is intended to induce a party to consent to a modification that would otherwise be a covered modification;
- that change is intended to compensate a party for a modification that is not a covered modification;
- that change is either a concession granted to a party to the contract experiencing financial difficulty or a concession secured by a party to account for the credit deterioration of another party;
- that change is intended to compensate a party for a change in rights or obligations that are not derived from the contract being modified; or
- the modification is identified in published guidance as having a principal purpose of achieving an unreasonable result in light of the purpose of the excluded modifications provision.
Examples provided in the Final Regulations further illustrate the operation of the rules outlined in the first four bullet points.
A “noncovered modification” is any modification that is not a covered modification and therefore the general rules under Treasury Regulations Section 1.1001-3 apply to determine whether the noncovered modification is treated as an exchange of property under Section 1001 of the Code.
Additional Rules Impacted by the Final Regulations
Real Estate Mortgage Investment Conduits
Under the Final Regulations, a covered modification of a regular interest in a REMIC that occurs after the “startup day” of the REMIC is disregarded in determining whether the regular interest has fixed terms on the startup day, a prerequisite of valid REMIC status. The Final Regulations also provide that an interest in a REMIC will not fail to qualify as a regular interest therein because it is subject to a contingency where a rate that references a discontinued IBOR and is a permitted variable rate may change to a fixed rate or different variable rate in anticipation of discontinued IBOR. In addition, the Final Regulations provide that an interest in a REMIC will not fail to qualify as a regular interest because it is subject to a contingency where the amount of payments of principal or interest is reduced by reasonable costs incurred to effect a covered modification. Thus, in general, a REMIC will not fail to qualify as a REMIC solely because its regular interests are modified to reference a qualified rate in a covered modification consistent with the Final Regulations.
Lastly, the Final Regulations provide that if a party other than the REMIC pays reasonable costs—such as costs to obtain tax opinions or rating agency approvals—incurred to implement any such alteration or modification, the payment will not be considered a contribution subject to the 100% tax.
An investment trust is not classified as a trust (and so may be taxable as a partnership or an association taxable as a corporation) if there is a power under the trust agreement to “vary the investment” of the certificate holders. Under the Final Regulations, neither a covered modification of a contract held by an investment trust, such as a grantor trust of the type typically used in a securitization transaction, nor a covered modification of an ownership interest in such an investment trust will be considered to manifest a power to vary the investment of the certificate holders, and so will not impact the status of the trust.
Integration and Hedging Transactions
If certain criteria are met, a taxpayer may integrate a debt instrument and a hedging transaction into a single instrument. Under the Final Regulations, a covered modification of a contract will not be treated as “legging out” of an integrated transaction, provided that the resulting financial instrument qualifies as a hedge within 90 days after the first covered modification of any component of the integrated transaction. The final regulations provide similar rules with respect to foreign currency hedges under Treasury Regulations Section 1.988-5(a) and transactions subject to the hedge accounting rules under Treasury Regulations Section 1.148-4(h).
Treasury Regulations provide rules that prevent the avoidance of tax by taxpayers that participate in arrangements using “fast-pay stock.” In certain circumstances, a modification of preferred stock intended to address the discontinuance of an IBOR-referencing rate may cause the stock following the modification to satisfy the definition of fast-pay stock. To address this issue, the Final Regulations provide that a covered modification of stock is not a “significant modification” for purposes of determining whether such stock is fast-pay stock. Notably, the Final Regulations further provide that if a covered modification and noncovered modification are made concurrently or as part of the same plan, and the noncovered modification is a significant modification, then Treasury Regulations Section 1.7701(l)-3(b)(2)(ii) and all of the facts and circumstances are considered in determining whether the stock is fast-pay stock.
Variable Rate Debt Instruments
As was the case under the Proposed Regulations, the Final Regulations treat the possibility of an IBOR-referencing rate becoming unavailable or unreliable as a remote contingency under the variable rate debt instrument (VRDI) rules and do not treat the change to a qualified rate as a change in circumstances, which avoids a VRDI from being treated as retired and reissued.
Foreign Account Tax Compliance Act
The Final Regulations provide that a covered modification of an existing contract that is “grandfathered” from compliance with obligations under the Foreign Account Tax Compliance Act (FATCA) will not be treated as a material modification—and therefore will not be treated as a significant modification subjecting the grandfathered contract to FATCA obligations.
Change in Accounting Method
The IRS and Treasury state in the preamble to the Final Regulations that a change from a discount rate that is based on a discontinued IBOR to a discount rate that is a qualified rate for purposes of valuing securities under the mark-to-market rules will not be viewed as a change in method of accounting under Section 446(e) of the Code, which requires the consent of the US Secretary of the Treasury.
The Final Regulations apply to modifications that occur on or after March 7, 2022. Taxpayers may generally rely on the Final Regulations for modifications that occurred prior to such date, provided the taxpayer and all related parties apply them consistently.
While the Final Regulations generally provide helpful guidance in connection with the transition away from IBOR-referencing rates, there are still open issues that remain. Additionally, unforeseen issues may arise as these Final Regulations are applied to real world fact patterns and modifications.
Qualified One Time Payments
The Final Regulations do not clarify how to determine the source and character of a qualified one-time payment. The preamble to the Final Regulations states that until further guidance is released, taxpayers may rely on the rules in the Proposed Regulations, which generally state 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 the payor.
Interest Expense of a Foreign Bank
Foreign banks can elect to compute interest expense attributable to excess US connected liabilities using the methodology in Section 882 regulations that rely on 30-day USD LIBOR. The Proposed Regulations permit foreign banks to elect to use a yearly average of SOFR.
Commentators have noted that a yearly average of SOFR is generally significantly lower than 30-day USD LIBOR. The Final Regulations do not provide further clarity. Instead, the preamble to the Final Regulations indicates that the Treasury and IRS are continuing to review this issue, and until future guidance is issued, foreign banks can apply the yearly average SOFR methodology in the Proposed Regulations.
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