Background

On Jan. 4, 2022, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) published final regulations (the Final Regulations) offering guidance to taxpayers with respect to the widely reported transition away from the use of the London Interbank Offered Rate (LIBOR) and other interbank offered rates (IBORs).[1] IBORs have been utilized as reference rates in trillions of dollars of debt instruments, derivatives and other contracts.

The Final Regulations reflect government and market participant efforts following the July 27, 2017, announcement of the U.K.’s Financial Conduct Authority (the FCA) that all currency and term variants of LIBOR may be phased out after 2021.[2] LIBOR’s administrator announced on March 5, 2021, that a number of tenors of U.S. dollar (USD) LIBOR will cease to be published immediately following June 30, 2023, and that publication of all other variants of LIBOR would cease immediately after Dec. 31, 2021.[3] Consequently, financial products and contracts referencing IBORs have been transitioning, and are expected to continue to transition, to SOFR or alternative rates, entailing modifications to such instruments. Such amendments generally take the form of a replacement of the IBOR-referencing rate with another rate or the replacement of an existing IBOR-referencing fallback rate with another fallback rate upon the discontinuance of the relevant IBOR. In either case, the replacement rate may include adjustments to the spread above the base reference rate to account for anticipated differences between the two rates and/or a one-time, lump-sum payment. In the absence of tax guidance of the type reflected in the Final Regulations, such changes could be treated as resulting in taxable exchanges under Section 1001,[4] possibly causing counterparties that are U.S. taxpayers to recognize sizable phantom income and potentially resulting in significant market disruption, notwithstanding the fact that no underlying economic rationale weighs in favor of a recognition event.

The Final Regulations seek to avert such market disruption by establishing special rules to avoid the realization of income, deduction, gain or loss for tax purposes and certain other potentially adverse tax consequences that otherwise may occur if parties modify contracts to replace reference rates. As discussed below, the Final Regulations aim to accomplish that goal by providing that changes in debt instruments, derivatives and other affected contracts to replace reference rates based on “discontinued IBORs” that constitute a “covered modification” will not result in tax realization events under Section 1001 and accompanying Treasury regulations.

The Final Regulations generally adopt proposed Treasury regulations (the Proposed Regulations) issued on Oct. 9, 2019, with certain amendments.[5] The Proposed Regulations similarly provided that modifications of debt instruments and other contracts in contemplation of an IBOR’s discontinuance would not be characterized as taxable exchanges. The Proposed Regulations also altered other tax rules to mitigate consequences of the transition away from IBORs. While many of the principal operative rules adopted in the Final Regulations carry over from the Proposed Regulations, structural changes reflected in the Final Regulations clarify the application of such rules. The Final Regulations also incorporate and amplify certain aspects of additional prior guidance released by the Service following the issuance of the Proposed Regulations.[6]  

Section 1001 Generally

Section 1001 provides rules for determining the amount and recognition of gain or loss from the sale or other disposition of property. Gain or loss is generally recognized upon the exchange of property for other property differing materially either in kind or in extent.

A significant modification of a debt instrument will result in a deemed exchange of such instrument for a modified instrument that differs materially either in kind or in extent for purposes of Section 1001. A modification of a debt instrument is generally any alteration of a legal right or obligation of the issuer or holder of the debt instrument unless such alteration occurs by operation of the instrument’s terms. An alteration treated as a modification must then be tested for significance. Absent guidance of the type set forth in the Final Regulations, changing the base reference rate could conceivably be treated as a significant modification and result in a recognition event.

In general, no rules analogous to those described in the immediately preceding paragraph specifically address when a modification of a non-debt contract such as a derivative or lease creates a recognition event for purposes of Section 1001. Absent additional guidance, modifying a non-debt contract to reflect the elimination of an IBOR could cause a deemed termination of the non-debt contract for tax purposes.

In the case of both debt instruments and non-debt contracts, absent additional guidance, the addition or modification of a fallback provision to address the possible elimination of an IBOR may result in a recognition event for tax purposes.

In a simplifying departure from the Proposed Regulations, the Final Regulations define the term “contract” expansively to include debt instruments, derivative contracts, insurance contracts, stock, leases and other contractual relationships. The Final Regulations handily provide a single set of rules for all debt and non-debt contracts to determine whether a modification of such contract to address the discontinuance of an IBOR will result in a taxable event.

Paragraphs (b) through (g) of Treasury Regulation § 1.1001-6 provide the operative rules for a “covered modification,” which modifications do not give rise to a taxable exchange. Treasury Regulation § 1.1001-6(j) sets forth certain excepted modifications expressly excluded from the definition of a “covered modification,” as well as a number of examples illustrating various types of covered and noncovered modifications in practice.

Treasury Regulation § 1.1001-6(h) defines a “covered modification” as a modification,[7] or portion of a modification, whereby the terms of a contract are modified:

  • To replace an operative rate that references a “discontinued IBOR” with a “qualified rate,” to add an obligation for one party to make a “qualified one-time payment” (if any), and to make “associated modifications” (if any);[8]
  • To include a qualified rate as a fallback to an operative rate that references a discontinued IBOR and to make associated modifications (if any); or
  • To replace a fallback rate that references a discontinued IBOR with a qualified rate and to make associated modifications (if any);[9]

provided that any such otherwise covered modification is not also one in which the terms of the contract are modified to change the amount or timing of contractual cash flows and such change is intended:

  • To induce one or more parties to perform any act necessary to consent to one of the covered modifications described above;
  • To compensate one or more parties for a modification to the contract apart from any of the covered modifications described above;
  • To grant a concession to a party to the contract because that party is experiencing financial hardship or to reflect a concession secured by a party to the contract to account for the credit deterioration of another party to the contract; or
  • To compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified.[10]

The Final Regulations include an anti-avoidance rule excluding from the scope of covered modifications those modifications changing the amount or timing of contractual cash flows identified in published guidance as having a principal purpose of achieving a result deemed unreasonable in light of the purpose of the Final Regulations. Any such guidance is anticipated to have a prospective effect.

The Final Regulations also address situations in which a covered modification is made contemporaneously with a “noncovered modification.”[11] In those cases, the general rules of Treasury Regulation § 1.1001-1(a) or § 1.1001-3, as appropriate, apply to determine whether the noncovered modification results in the exchange of property for other property differing materially in kind or in extent. In applying those general rules, the covered modification is treated as part of the terms of the contract prior to the noncovered modification.

Integrated Transactions and Hedges

Debt instruments and hedges may be treated in certain circumstances as an integrated instrument under the Code (e.g., Treasury Regulation § 1.1275-6 provides rules pursuant to which certain debt instruments and one or more hedges may be integrated for purposes of determining the character and timing of a taxpayer’s income, deduction, gain or loss). Absent additional guidance, amending an instrument or corresponding hedge to address the elimination of an IBOR may cause a dissolution of the integrated instrument, potentially resulting in adverse tax consequences for one or more parties to the transaction.

The Final Regulations provide that a covered modification of one or more contracts that are part of an integrated transaction or a qualified hedging transaction under Treasury Regulation § 1.1275-6 or Treasury Regulation § 1.988-5 (relating to foreign currency transactions), respectively, is not treated as legging out of such transaction, provided that no later than the end of a 90-day grace period beginning on the date of the first covered modification of any such contract, the financial instrument that results from any such covered modification satisfies the requirements to be a hedge with respect to the qualifying debt instrument that results from any such covered modification. The Final Regulations further provide that if a taxpayer enters into an interim hedge intended to mitigate the economic effect of a temporary mismatch of the legs of the integrated transaction during that 90-day period, (i) the integration of the interim hedge with the other components of the integrated transaction during the 90-day period is treated as not legging into a new integrated transaction or qualified hedging transaction, and (ii) the termination of the interim hedge before the end of the 90-day period is treated as not legging out of the existing integrated transaction or qualified hedging transaction, as the case may be. The Final Regulations apply similar rules with respect to transactions subject to the hedge accounting rules under Treasury Regulation § 1.446-4, as well as hedging transactions for bonds integrated as qualified hedges under Treasury Regulation § 1.448-4(h) for purposes of the arbitrage investment restrictions applicable to certain tax-exempt and other tax-advantaged bonds.

Grandfathered Obligations Under FATCA

Under Treasury Regulation § 1.1471-2(b), a withholdable payment for purposes of the FATCA provisions of the Code generally does not include a payment made under a grandfathered obligation. A grandfathered obligation includes any obligation outstanding on July 1, 2014, and an obligation includes debt instruments, certain credit agreements and derivatives transactions. In general, a debt obligation is considered outstanding on July 1, 2014, if it has an issue date before such date. Other obligations are considered outstanding on such date if a legally binding agreement establishing such obligation was executed before such date. However, a material modification of an outstanding obligation results in the obligation being treated as newly issued or executed as of the date of such modification. Treasury Regulation § 1.1471-2(b)(2)(iv) provides that in the case of a debt obligation, a material modification is any significant modification of the debt instrument as defined in Treasury Regulation § 1.1001-3(e). In other cases, whether a modification is material is based on the facts and circumstances. The Final Regulations provide that a covered modification is not a material modification of a contract for purposes of Treasury Regulation § 1.1471-2(b)(2)(iv).  

OID and Qualified Floating Rate

Treasury Regulation § 1.1275-5 provides rules for determining the amount and accrual of qualified stated interest and original issue discount (OID) with respect to a variable rate debt instrument (VRDI). A VRDI may provide for stated interest at one or more qualified floating rates (QFRs). In general, a variable rate is a QFR if variations in value of the rate are reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds. If a debt instrument provides for two or more QFRs that can reasonably be expected to have approximately the same values throughout the term of the instrument, the QFRs together constitute a single QFR. If a VRDI provides for stated interest at a single QFR, the amount of any OID that accrues may be determined under the rules generally applicable to fixed rate debt instruments.

Under Treasury Regulation § 1.1275-2(m), if a VRDI provides both for a QFR that references a discontinued IBOR and a fallback methodology upon the unavailability of such IBOR, the original rate and the fallback rate are treated as a single QFR for purposes of Treasury Regulation § 1.1275-5. Moreover, the Final Regulations provide that a VRDI will not be treated as retired and then reissued, with attendant tax consequences, when the relevant IBOR becomes unavailable and the rate switches to the fallback rate.

Fast-Pay Stock

Treasury Regulation § 1.7701(l)-3 provides rules recharacterizing certain financing arrangements involving fast-pay stock to ensure the participants are taxed in accordance with the economic substance of the arrangement. Stock is considered fast-pay stock if dividends paid by the corporation with respect to its stock are economically a return of the holder’s investment (as opposed to a return on the holder’s investment). Unless a presumption otherwise applies, the determination of whether stock is fast-pay stock is based on all the facts and circumstances. Stock is examined for fast-pay status when issued or when there is a significant modification in the terms of the stock or a related agreement or a significant change in the relevant facts and circumstances.

The Final Regulations provide that a covered modification of stock is not such a significant modification or a significant change in the relevant facts and circumstances for purposes of the fast-pay rules. However, if a covered modification is made at the same time as, or as part of a plan that includes, a noncovered modification, and the noncovered modification amounts to a significant modification or a significant change in the relevant facts and circumstances, then the general rules apply to determine whether the stock is fast-pay stock.

Investment Trusts

Treasury Regulation § 301.7701-4(c)(1) provides that an investment trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders. The Final Regulations provide that a covered modification of a contract held by an investment trust is not considered such a power. Moreover, a covered modification of an ownership interest in an investment trust does not amount to a power to vary the investment of the certificate holder.

Source and Character of One-Time Payments

The Proposed Regulations provide that for all purposes of the Code, including the withholding rules, the source and character of a one-time payment made by a payor as compensation for any reduction in payments attributable to the differences between the IBOR and the new reference rate are the same as the source and character that would otherwise apply to a contractual payment made by such payor. Treasury and the Service are continuing to consider, among other things, how this rule should apply to certain financial contracts, as well as the timing of any tax items associated with such one-time payments. The Preamble to the Final Regulations indicates that until further guidance is forthcoming, taxpayers may rely on the rule in the Proposed Regulations to determine the source and character of a qualified one-time payment

REMICs

Section 860G(a)(1) provides that a REMIC regular interest must be issued on the startup day with fixed terms. Moreover, interest payments thereon may be payable at a variable rate only as provided in regulations, and a regular interest must generally entitle the holder to receive a specified principal amount. Contributions to a REMIC after the startup day are generally subject to a tax equal to 100% of such amounts.

The Final Regulations provide that a covered modification of a regular interest in a REMIC occurring after the startup day is disregarded in determining whether such interest has fixed terms on the startup day. Additionally, a REMIC interest does not fail to qualify as a regular interest solely because it is subject to a contingency whereby a rate that references a discontinued IBOR and is a permitted variable rate may change to a fixed rate or a different permitted variable rate in anticipation of the IBOR’s unavailability or unreliability. Moreover, the Final Regulations confirm that a REMIC interest does not fail to qualify as a regular interest solely because it is subject to a contingency whereby the amount of payments of principal or interest (or other similar amounts) with respect to such interest is reduced by reasonable costs (e.g., the cost of obtaining a tax opinion or rating agency confirmations) incurred to effect a covered modification, and payment by a party other than the REMIC of such reasonable costs is not regarded as a contribution to the REMIC after the startup day.

Foreign Bank Interest Expense

The Proposed Regulations amend an election under current regulations allowing a foreign corporation that is a bank to compute interest expense attributable to certain U.S.-connected liabilities for purposes of Section 882(c) (relating to interest expense allocation) by substituting a yearly average SOFR for a rate referencing 30-day LIBOR. As the result of a public comment to the effect that a yearly average of SOFR is typically less than 30-day USD LIBOR, and is therefore not a suitable equivalent, Treasury and the Service continue to study the appropriate rate to replace LIBOR. Until final regulations are published that replace the LIBOR election, taxpayers may continue to apply either the general rule or the annual published rate election provided under Treasury Regulation § 1.882-5(d)(5)(ii) to calculate interest on excess U.S.-connected liabilities. Taxpayers may also continue to rely on the yearly average SOFR rule in the Proposed Regulations. Treasury and the Service anticipate issuing additional guidance before 30-day USD LIBOR is discontinued in 2023. 

Change of Accounting Method

Section 446(e) provides in general that a taxpayer changing the method of accounting on the basis of which it regularly computes its income in keeping its books must obtain consent before computing its taxable income under the new method. The Preamble to the Final Regulations indicates that a change from a discount rate 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 in Section 475 will not constitute a change in method of accounting under Section 446(e).

Applicability Dates

Treasury Regulation § 1.860G-1(e) applies with respect to covered modifications occurring, or REMIC regular interests issued, on or after March 7, 2022, as the case may be. However, taxpayers may elect to apply such rules with respect to covered modifications occurring, or REMIC regular interests issued, before March 7, 2022.

Treasury Regulation § 1.1001-6 applies to contractual modifications occurring on or after March 7, 2022. A taxpayer may choose to apply such rules to modifications occurring before March 7, 2022, provided that the taxpayer and all related parties (as defined in Treasury Regulation § 1.1001-6(k)) apply such rules to all contractual modifications that occur before that date.

Treasury Regulation § 1.1275-2(m) applies to debt instruments issued on or after March 7, 2022. Taxpayers may elect to apply those rules to debt instruments issued before March 7, 2022, provided that the taxpayer and all related parties (as defined in Treasury Regulation § 1.1275-2(m)(5)) apply such rules to all debt instruments issued before that date.

*****

If you have any questions about the issues addressed in this alert or you would like a copy of any of the materials mentioned, please contact any of the authors.   


[1] See T.D. 9661, 87 Fed. Reg. 166 (Jan. 4, 2022). Prior to Jan. 1, 2022, LIBOR was published in seven tenors (overnight/spot next, 1 week, 1-month, 2-month, 3-month, 6-month and 12-month) across five currencies based on submissions provided by a panel of banks. Such submissions were intended to reflect the interest rate at which banks could borrow funds on unsecured terms in wholesale markets.

[2] The  Alternative Reference Rates Committee (the ARRC), convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York, recommended the use of the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities, based on approximately $1 trillion of transactions each day. The ARRC has also published recommended reference rate fallback language for inclusion in the terms of certain instruments, such as syndicated loans and securitizations, in preparation for the discontinuance of LIBOR. Additionally, the ARRC has worked with the International Swaps and Derivatives Association (ISDA) to ensure that fallback provisions in derivative contracts will not result in market turmoil in a post-LIBOR world. In that connection, ISDA developed its 2020 IBOR Fallbacks Protocol pursuant to which parties to certain derivatives can incorporate enhanced fallback terms in such contracts. A fallback provision specifies what is to occur upon an IBOR’s discontinuance or significant impairment as a reliable benchmark.

[3] On Sept. 29, 2021, the FCA announced that LIBOR’s administrator would continue to publish one-month, three-month and six-month sterling LIBOR and Japanese yen LIBOR after Dec. 31, 2021, using a synthetic methodology. The FCA also indicated that it may compel the administrator to publish one-month, three-month and six-month USD LIBOR after June 30, 2023, using a similar synthetic methodology. However, these synthetic LIBOR variants are only expected to be published for a limited period of time.

[4] All section references are to sections of the Internal Revenue Code of 1986, as amended (the Code), unless otherwise indicated.

[5] For an overview of the Proposed Regulations, see https://www.kramerlevin.com/en/perspectives-search/proposed-regulations-mitigate-tax-issues-lurking-in-libor-referencing-debt-instruments-and-other-contracts.html

[6] See Rev. Proc. 2020-44, 2020-45 I.R.B. 991 (supporting the adoption of the ARRC’s recommended fallback provisions and ISDA’s 2020 IBOR Fallbacks Protocol discussed above). Rev. Proc. 2020-44 generally provides that a modification within its scope is not treated as an exchange for purposes of Treasury Regulation § 1.1001-1(a).

[7] A “modification” of the terms of a contract includes any modification of the terms of the contract, regardless of its form. A modification may be evidenced by, among other things, an express oral or written agreement or the conduct of the parties.

[8] A “discontinued IBOR” is defined as one in which the IBOR administrator or an official or body thereover announces that such administrator has ceased or will cease to provide the IBOR permanently or indefinitely, and no successor administrator is expected to continue to provide the IBOR, but only during the period beginning on the date of such announcement and ending one year after the date on which the administrator ceases to provide the IBOR.  

Treasury Regulation § 1.1001-6(h)(3) identifies a number of “qualified rates,” including SOFR, the Sterling Overnight Index Average, the Tokyo Overnight Average Rate, the Swiss Average Rate Overnight and the euro short-term rate, and sets forth certain rules for determining whether multiple, indeterminable and remote fallback rates meet the requirements to be a qualified rate.

A “qualified one-time payment” is a single cash payment intended to compensate the other party or parties for all or part of the basis difference between the discontinued IBOR in question and the interest rate benchmark to which the qualified rate refers. Any amount in excess of that amount is a noncovered modification.

An “associated modification” is a modification of the technical, administrative or operational terms of a contract that is reasonably necessary to adopt or implement the covered modifications described above, as well as an incidental cash payment intended to compensate a counterparty for small valuation differences resulting from a modification of the contract’s administrative terms. A payment of a non-incidental amount will not qualify as an associated modification.

[9] Treasury Regulation § 1.1001-6(h) further provides that any modification of the terms of a contract described in Rev. Proc. 2020-44 or described in other published guidance supplementing the modifications described therein is treated as a covered modification.

The Preamble to the Final Regulations indicates that a change to the terms of a contract that results from the subsequent activation of a fallback provision must be tested at such time to determine whether a Section 1001 exchange is deemed to take place. If the change resulting from such activation is itself a covered modification, then the covered modification rules apply to that change. If not, whether that change will be deemed to be an exchange is generally determined under Treasury Regulation § 1.1001-3 (for debt instruments) or Treasury Regulation § 1.1001-1(a) (for other contracts).

[10] As a result of these excluded modifications, covered modifications include only modifications to the cash flows of an IBOR-referencing contract meant to address the replacement of such rate.

[11] A noncovered modification is any modification, or portion of a modification, of the terms of a contract that is not a covered modification and includes those modifications changing the amount or timing of contractual cash flows described above that are expressly carved out from the definition of a covered modification.