On October 8, 2019, the Treasury Department and IRS issued proposed regulations confirming that transitions from LIBOR and other interbank offered rates (IBORs) to alternative reference rates in debt instruments and derivatives will not be taxable events.  This guidance was eagerly anticipated because countless instruments will have to be amended to provide for new reference rates before IBORs are phased out as early as the end of 2021.  If these amendments were treated as significant modifications for U.S. tax purposes, they could have severely adverse consequences for market participants.  We previously summarized some of these consequences here and in an industry group letter to the IRS co-authored by tax partners Jason Schwartz and Gary Silverstein.

Very generally, under the proposed regulations, the modification of an instrument to replace an IBOR-based rate with a SOFR-based or other qualified replacement rate will not be treated as a “modification” for U.S. tax purposes, and thus will not give rise to a taxable event, if (1) the fair market value of the modified instrument is substantially equivalent to the fair market value of the unmodified instrument and (2) the replacement rate is based on transactions conducted in the same currency as the IBOR-based rate or is otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency as the IBOR-based rate.

Qualified Replacement Rates.  The proposed regulations enumerate several qualified replacement rates in addition to SOFR.^[1]  Qualified replacement rates also generally include (1) rates endorsed or recommended by a central bank, reserve bank, monetary authority or similar institution as an IBOR replacement and (2) other floating rates that can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds in the instrument’s relevant currency.

Fair Market Value Test.  A rate will not be a qualified replacement rate unless the fair market value of the modified instrument is substantially equivalent to the fair market value of the unmodified instrument (determined using a reasonable, consistently applied valuation method and taking into account the value of any one-time payment that is made in connection with the modification).

The proposed regulations include two safe harbors for determining fair market value:

• Historic Average. The historic average safe harbor is satisfied if, on the modification date, the historic average of the replacement rate (adjusted to account for any one-time payment made in connection with the modification) is no more than 25 basis points from the historic average of the IBOR-based rate.  A historic average may be determined by using an industry-wide standard or a continuous look-back of up to 10 years.
• Arm’s-Length. The arm’s-length safe harbor is satisfied if the parties are unrelated and determine, based on bona fide, arm’s-length negotiations, that the fair market value of the modified instrument is substantially equivalent to the fair market value of the unmodified instrument.

As the phase-out of IBORs and corresponding phase-in of alternative rates could impact the fair market values of instruments that reference these rates, taxpayers may have difficulty administering the fair market value test if neither of the safe harbors is available.

Contemporaneous Modifications.  A modification that is associated with the designation of a qualified replacement rate and that is reasonably necessary to adopt or implement that designation is not treated as a modification for U.S. tax purposes, and therefore does not give rise to a taxable event.  Examples of these modifications are (1) a change of payment dates necessitated by the use of a new reference rate or (2) the obligation of a party to make a one-time payment to the other party to offset the change in value of the instrument that would result from adopting a new reference rate.

Any other modifications (for example, an increase in a debt instrument’s interest rate to reflect a deterioration in the borrower’s creditworthiness) must be tested separately to determine whether they give rise to a taxable event.  For this purpose, the “baseline” against which such other modifications are tested is the instrument immediately after the designation of a new reference rate.

One-Time Payments.  The proposed regulations recognize that a modification may require a party to make a one-time payment to the other party to offset the change in value of the instrument that would result from adopting a new reference rate.  Under the proposed regulations, the source and character of this one-time payment is the same as the source and character that would otherwise apply to a payment made by the payer under the instrument.

This rule appears intended to treat one-time payments by borrowers as interest income that can qualify for the portfolio interest exemption from U.S. withholding tax, although it would be helpful if final regulations clarified this intent.  It is unclear how a one-time payment by a lender should be treated, and the preamble to the proposed regulations requests comments on this.  It also may not always be clear how the rule should apply with respect to derivatives, where some payments by a party may be treated as giving rise to capital gain or loss and others may be treated as ordinary income.

Conforming Regulatory Amendments.  The proposed regulations would make a number of conforming changes that flow directly from the general non-recognition rule.

• REMICs. A securitization vehicle will not fail to qualify as a REMIC solely because its regular interests are modified to reference a qualified replacement rate in accordance with the proposed regulations, or are subject to a reduction of principal or interest (or similar amounts) for costs incurred to effect the modification.
• Integration, Hedging, and Grandfathering. A modification in accordance with the proposed regulations generally will not cause a taxpayer to be treated as disposing of or terminating a leg of an integrated transaction or hedge, and will not cause an instrument to lose its grandfathered status under FATCA or section 871(m).
• Contingent Payment Debt Instruments. A floating rate debt instrument’s use of a qualified replacement rate as a fallback rate will not cause that debt instrument to be treated as a contingent payment debt instrument and will not create or increase the amount of original issue discount on the instrument.

Effective Date.   The proposed regulations would apply to modifications that occur on or after the date that they are finalized.  However, taxpayers generally may rely on the proposed regulations if they and their related parties apply them consistently.

[1]   These rates are rates based on SONIA, TONAR, SARON, CORRA, HONIA, the RBA cash rate, or €STR.