Regulators have cautioned that LIBOR—which serves as a reference rate for approximately $35 trillion dollars of debt and derivatives—will be phased out as early as the end of 2021.  As a result, countless instruments will have to be amended to provide for a new reference rate.  If these amendments are treated as "material modifications," they could significantly affect the parties to the instruments.

Material Modifications

A material modification of an investment generally is treated for tax purposes as a taxable exchange of the investment for a new investment.

In the debt context, a material modification (often referred to alternatively as a "significant modification") generally occurs if (1) the modification does not occur by operation of the terms of the instrument and (2) the modification changes the instrument's yield by more than the greater of (x) 0.25% and (y) 5% of the unmodified yield.  It is not always clear how to apply these rules.

In the non-debt context, there are no bright-line rules for what constitutes a material modification.  Accordingly, any modification is at risk of being treated as a material modification.

Summary of Potential Tax Consequences

• Withholding on U.S. equity-linked swaps and other derivatives. Many U.S. equity-linked derivatives provide for a LIBOR-based return to the short party. Under Section 871(m) of the tax code, certain U.S. equity-linked derivatives that were "issued" after 2020 and are held by a non-U.S. person may be subject to 30% withholding tax if, at issuance, they have a delta of at least 0.80 with respect to the underlying stock or certain other conditions are satisfied. A material modification of these derivatives may be treated as a new issuance for this purpose. Thus, taxpayers may be required to build withholding and reporting systems with respect to derivatives that, absent a reference rate amendment, might otherwise have been "grandfathered" out of Section 871(m) withholding.
• Withholding on U.S. debt instruments. Under Sections 1471-1474 of the Code, commonly referred to as FATCA, U.S. debt instruments (and any other instruments that give rise to U.S.-source income) that were "issued" on or after July 1, 2014 and that are held by a non-U.S. person may be subject to withholding if the non-U.S. person is a foreign financial institution that fails to certify as to its compliance with certain information reporting requirements or is a non-financial foreign entity that fails to provide certain certifications regarding its substantial U.S. owners. A material modification may be treated as a new issuance for this purpose. Thus, taxpayers may be required to build withholding and reporting systems with respect to long-dated debt instruments and potentially other instruments that, absent a reference rate amendment, might otherwise have been "grandfathered" out of FATCA.
• Tax recognition for all contracts, including debt and "bullet swaps." Gain from the disposition of an investment generally is treated as long-term capital gain (which generally is taxed to individuals at preferential rates) if, at the time of the disposition, the investment was held for more than one year. A material modification of an investment generally causes the investment to be treated as disposed of and reissued for U.S. tax purposes. Accordingly, an amendment to an investment's reference rate could require a holder to recognize taxable gain earlier than anticipated and to be taxed at short-term capital gains rates. 
• COD income for debtors; gain for creditors. A material modification of debt is treated as a retirement and reissuance of that debt. If the debt has a face amount of more than $100 million and one or more broker-dealer quotes are available for the debt, then the price at which it is deemed to have been retired generally is its fair market value at the time of the material modification. Under certain circumstances, a debtor is required to recognize cancellation of debt (COD) income if it retires its own debt for an amount that is less than the debt's principal amount. Accordingly, if, at the time of a reference rate amendment, a debt instrument trades at less than its principal amount, the debtor may have COD income. Conversely, if, at the time of a reference rate amendment, a debt instrument trades at more than its principal amount, then the creditor may have taxable gain.
• Change in entity classification for securitizations. Many mortgage-backed securitizations are structured as real estate investment conduits (REMICs) for U.S. tax purposes. Alternatively, many securitizations are structured as grantor trusts for U.S. tax purposes. REMICS and grantor trusts are limited in their ability to materially modify the debt instruments that they hold. A material modification of these debt instruments could cause (1) a REMIC to lose its REMIC status and be taxed on its net income as a domestic corporation, in which case holders of certain REMIC certificates could be treated as receiving dividends (which are generally subject to 30% U.S. withholding tax when paid to non-U.S. persons) instead of interest, and (2) a grantor trust to be treated as either (A) a "taxable mortgage pool" that is taxed on its net income as a domestic corporation, in which case holders of certain notes issued by the trust could be treated as receiving dividends (which are generally subject to 30% U.S. withholding tax when paid to non-U.S. persons) instead of interest, or (B) a partnership, in which case interest earned by the entity on its assets and allocable to non-U.S. persons could become subject to 30% U.S. withholding tax. Accordingly, the replacement of LIBOR could have disastrous consequences for the securitization industry.  Industry participants are mobilizing to lobby for administrative relief.