LIBOR Transition: Borrower Tax Consequences and Proposed Regulations
The London Interbank Offered Rate (LIBOR), one of the pillars of modern finance, will be phased out after the end of 2021. As of January 1, 2022, no new U.S. dollar LIBOR loans may be made. Existing legacy loans that bear interest based on one-, three- or six-month LIBOR may continue until June 30, 2023, and then they too will have to switch to an alternative reference rate (ARR). Among the many questions that U.S. borrowers have been, or should be, asking is whether the change from LIBOR to another rate will subject them to adverse U.S. tax consequences.
At first blush, a change in the interest rate benchmark used in a loan might appear to be a relatively simple matter. However, often lost among the legal and contractual challenges surrounding modifications of loan agreements or notes are the potential (and often adverse) tax consequences that may result when the terms of a loan agreement or note are modified. Under Internal Revenue Service, Treasury Regulation section 1.1001-3, the modification of a loan agreement or note is treated for federal income tax purposes as the exchange of the original debt loan agreement or note for a modified loan agreement or note if the modification is “significant.” This deemed exchange is a taxable event that may result in gain or loss for the holder/creditor, cancellation of indebtedness income for the issuer/debtor, and/or the unintended creation of original issue discount. A “modification” is generally any alteration of a legal right or obligation under a debt instrument, whether evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. If modifying the interest rate index is considered a significant modification to a loan agreement or note, it could be a major headache for borrowers to have to address.
On October 9, 2019, The Treasury Department and the IRS released proposed regulations at 84 F.R. 54068 (the “Proposed Regulations”) to offer guidance on the tax implications concerning the LIBOR transition. That was followed on October 9, 2020, by Revenue Procedure 2020-44 (the “Revenue Procedure”). The Treasury Department and the IRS have stated that they anticipate that the Proposed Regulations and Revenue Procedure will minimize potential financial disruption and facilitate the market’s adjustment to the termination of LIBOR in a cost-efficient manner.
Section 1.1001-6(a) of the Proposed Regulations generally provides that altering the terms of a debt instrument or modifying the terms of a non-debt contract to provide a replacement or fallback reference rate for the LIBOR benchmark with a “qualified rate” would not result in tax realization events under section 1001 of the Tax Code or sections 1.1001-1 and 1.1001-3 of the Treasury Regulations.
This treatment also applies to “associated alterations,” which are alterations that are both associated with and reasonably necessary to adopt an ARR. An associated alteration may be a technical, administrative or operational alteration, such as a change to the definition of “interest period” or a change to the timing and frequency of determining rates and making payments of interest (e.g., delaying payment dates on a debt instrument by two days to allow sufficient time to compute and pay interest at a qualified rate computed in arrears). Another example of an associated alteration is the obligation for a party to make a one-time payment in addition to or in lieu of a spread adjustment to offset or mitigate the change in value of the instrument that results from the replacement.
Qualified Rate Test
Section 1.1001-6(b) of the Proposed Regulations establishes a three-prong test (the “Qualified Rate Test”) to determine if a rate is a “qualified rate”:
- Assuming that prongs (2) and (3) are satisfied, the rate may be the Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (“SOFR”) or one of the seven other enumerated rates under section 1.1001-6(b)(1), any rate endorsed or recommended by a central bank or similar authority, and any qualified floating rate under Treas. Reg. section 1.1275-5;
- The fair market value (“FMV”) of the debt instrument or non-debt contract after the alteration or modification must be substantially equivalent to the fair market value of the debt instrument or non-debt contract before the alteration or modification, using any reasonable, consistently applied valuation method and taking into account the value of any one-time payment made in connection with the alteration or modification;
- The rate must be based on transactions conducted in the same currency as the LIBOR benchmark it replaces.
The Proposed Regulations provide two safe harbors for establishing fair market value.
- The Rate Comparison Safe Harbor: The first safe harbor is satisfied if the historic average of the qualified ARR does not differ from the historic average of the LIBOR benchmark it replaces by more than 25 basis points on the date of alteration or modification. The historic average must be determined: (1) in good faith, and (2) by using any industry-wide standard, such as the methods recommended by the Alternative Reference Rates Committee (ARRC), the International Swaps and Derivatives Association (ISDA), or any reasonable method that takes into account every instance of the relevant rate published during a continuous period beginning no earlier than 10 years before the alteration or modification and ending no earlier than three months before the alteration or modification. This safe harbor provision essentially transforms the method of determining the spread adjustment in order to avoid fair market value (FMV) calculations.
- The Arm’s-Length Safe Harbor: The second safe harbor is satisfied if unrelated parties determine that the FMV of the debt instrument or non-debt contract before the alteration or modification is substantially equivalent to the FMV after the alteration or modification based on bona fide, arm’s-length negotiations.
The Proposed Regulations also provide guidance on other matters potentially impacted by the change in reference rate due to the transition from LIBOR.
- Integrated or Hedged Transactions: The modification of a debt instrument or derivative contract that is part of an integrated or hedged transaction may result in the recognition of gain or loss. The Proposed Regulations provide that taxpayers may modify the integrated or hedged transaction, or either leg of such a transaction, to replace LIBOR with a qualified rate without “legging out” of the integrated or hedged transaction, or terminating either leg of the transaction, and being subject to tax consequences.
- Grandfathered Financial Instruments: Financial instruments that are “grandfathered” out of, or exempt from, tax withholding under the Foreign Account Tax Compliance Act (FATCA) may lose this protected status and therefore be subject to recharacterization as equity if they are significantly modified. The Proposed Regulations provide that grandfathered financial instruments that are modified to replace the LIBOR benchmark with an ARR will neither lose their tax-exempt status nor be treated as reissued.
- Original Issue Discount (OID): An OID note is a variable rate debt instrument (VRDI) that may be treated as retired and reissued if it experiences a significant modification. Such a change in circumstances may subject the debtor to income inclusion. If the debt instrument is deemed to have been retired at a price that is less than the instrument’s principal amount, then a debtor may need to recognize cancellation of debt (COD) income. On the other hand, if the price is higher than the principal amount, then the creditor may be subject to taxable gain. The Proposed Regulations provide that an OID will not be treated as retired and reissued when LIBOR becomes unavailable and the rate changes to the fallback rate.
- Real Estate Mortgage Investment Conduit (REMIC): A REMIC must have fixed terms on its startup day to meet the regular interest requirements under section 860G of the Tax Code. If a REMIC were to acquire a new loan after the startup day, it would lose its regular interest status and be subject to a 100-percent “prohibited transactions” tax on any net income from the loan. Modifying a REMIC to provide an ARR or fallback provisions to replace LIBOR may be considered an acquisition of a new loan and thus adversely impact investors. The Proposed Regulations provide that modifying a REMIC to replace the LIBOR benchmark with a qualified ARR or to add fallback language would not be treated as acquiring a new loan after the startup day.
- Interest Expense of a Foreign Corporation: A foreign corporation that is a bank may only elect a 30-day LIBOR to compute the interest expense of U.S.-connected liabilities instead of determining its average USD borrowing cost. Once LIBOR is phased out, this exclusive election will no longer be available. The Proposed Regulations provide that foreign banks may use a yearly average SOFR in place of the 30-day LIBOR.
Please note that a modification that is: (1) not covered by the Proposed Regulations, and (2) made contemporaneously with a modification covered by the Proposed Regulations may still result in tax consequences.
Like the Proposed Regulations, Revenue Procedure 2020-44 (Revenue Procedure) was developed to help facilitate the market’s transition away from LIBOR to a qualified ARR. While some financial instruments that reference USD LIBOR contain fallback language, many of these provisions do not adequately protect against the termination of the LIBOR benchmark. Thus, the Treasury Department and the IRS decided to issue guidance through the Revenue Procedure before finalizing the Proposed Regulations to promote and encourage the adoption of fallback language recommended by the ARRC and ISDA.
- ARRC Fallback: The ARRC Fallback provides recommended language for securitizations, syndicated loans, bilateral business loans, variable-rate private student loans, adjustable rate mortgages, and floating rate notes to transition to SOFR.
- ISDA Fallback: ISDA encourages companies to follow its fallback protocol as a form of insurance. ISDA claims that parties may still engage in bilateral agreements to transition to SOFR or any other ARR even after signing up for the protocol.
In addition, similar to the Proposed Regulations, the Revenue Procedure provides that modifying a financial instrument to incorporate the ARRC Fallback, ISDA Fallback, or a provision substantially similar to either of the two provisions (under certain circumstances), would not result in a recognition event under section 1001 of the Tax Code. The Revenue Procedure also provides that modifying an integrated or hedged transaction, or either leg of such a transaction, to incorporate the above-mentioned fallback provisions would not result in “legging out” of the integrated or hedged transaction or terminating either leg of the transaction.
The reference to the ARRC Fallback and the ISDA Fallback language is useful, but also limiting in that these sources only contemplate SOFR to the exclusion of other ARRs and apply highly specific language that parties may otherwise wish to modify. The Revenue Procedure is also limited in duration in that it is effective for modifications to financial instruments occurring on or after October 9, 2020, and before January 1, 2023. After the Revenue Procedure was issued, the regulators for LIBOR agreed that LIBOR will continue to be published for legacy loans until June 30, 2023. Hopefully by January 1, 2023, most borrowers will have already made the transition to an ARR, or the Revenue Procedure will have been extended.