Following up on our past LIBOR posts (see “The LIBOR Transition – What is LIBOR and why is it important?” and “The LIBOR Transition – the Secured Overnight Financing Rate (SOFR)”) on the transition away from LIBOR (London Interbank Offering Rate), and other interbank offering rates denominated in other currencies (collectively with LIBOR, “IBOR”), we discuss in this post the US Internal Revenue Service’s (“IRS”) proposed “Guidance on the Transition From Interbank Offered Rates to Other Reference Rates,” (“Proposed Guidance”) published for comment on October 9, 2019.
The proposed regulations would provide much-needed guidance on the tax consequences of the transition from IBOR and is necessary to address the issue of amending contract terms to replace an IBOR. One of the overall concerns with replacement of IBOR is the potential tax consequences of using a new reference rate in an amended contract.
The primary tax issues raised by the switch from IBOR are:
- Issue: If no provision has been made in the terms of the debt instrument for such a change, whether changing the interest rate index referenced in a US dollar-denominated debt instrument from USD LIBOR to the Secured Financing Overnight Rate published by the Federal Reserve Bank of New York (“SOFR”) is an alteration of the terms of the debt instrument that could be seen as a “significant modification” and thus result in a “tax realization event.”
- IRS Proposal: So long as the alteration or modification does not change the fair market value of the instrument or contract or change the currency of the reference rate, the alteration or modification does not result in the realization of income, deduction, gain, or loss under the Proposed Guidance.
- Issue: Whether amending an integrated IBOR-referencing debt instrument or hedge to address the elimination of the IBOR may cause a deemed termination that could result in the integrated instrument separating into its component parts, which could result in adverse tax consequences.
- IRS Proposal: Taxpayers may alter the terms of a debt instrument, or revise the other components of an integrated or hedged transaction, in order to replace an IBOR reference rate with a new reference rate without affecting the tax treatment of the underlying transaction or the hedge.
- Issue: Would the IRS deem a one-time payment to compensate for the difference in payments in changing from IBOR to another reference rate change the source and character of a debt instrument or non-debt contract and the withholding rules.
- IRS Proposal: So long as the payment is made in accordance with certain conditions, replacement of the reference rate would not change the source and character of the instrument or contract, and the replacement would be treated the same as the source and character that would otherwise apply to a payment made by the payor with respect to the revised instrument or contract.
- Issue: Would grandfathered debt instruments and non-debt contracts now treated as tax-exempt lose the exemption if the IRS treats those now-exempt contracts as reissued as a consequence of the modification.
- IRS Proposal: Generally, grandfathered debt instruments and non-debt contracts will not be considered reissued and would not lose their tax exempt status following a modification stemming from elimination of the IBOR reference rate.
- Issue: Would variable rate debt instruments (“VRDIs”), such as original issue discount notes, that reference IBOR still continue to qualify as VRDIs or are there non-remote contingencies that need to be considered.
- IRS Proposal: IBOR becoming unavailable will be treated as a remote contingency and not as a change in circumstances.
- Issue: Would the change in reference rate, or addition of fallback provisions, in a regular interest in a real estate mortgage investment conduit (“REMIC”) preclude the interest from continuing as a regular interest.
- IRS Proposal: The interest in the REMIC would retain its status as a regular interest despite the revision in the reference rate or addition of fallback language.
- Issue: What happens if LIBOR is phased out where the interest expense of a non-US bank can use only 30-day LIBOR as a reference rate.
- IRS Proposal: A non-US bank can compute interest expense attributable to excess U.S.-connected liabilities using a yearly average SOFR.
Comments were due on or before November 25, 2019.
“The LIBOR Transition” is a periodic series of updates discussing reference interbank offering rates, such as LIBOR, and the challenges involved in navigating a successful transition from their use as reference rates of choice in the market. Norton Rose Fulbright has assembled a group of its lawyers from around the globe to stay on top of these issues and assist clients in the transition to new reference rates. More information can be found on our Norton Rose Fulbright web site.