On Wednesday, October 9, 2019 the Treasury Department published proposed regulations, primarily under Section 1001 of the Internal Revenue Code of 1986, as amended (the “Code”), in an attempt to clarify the federal income tax consequences resulting from the transition to the use of reference rates other than interbank offered rates (“IBOR”s, which include USD LIBOR) in debt instruments and non-debt contracts as a result of the U.K. Financial Conduct Authority’s statement that it would no longer compel banks to submit quotes for LIBOR beginning after 2021. With respect to IBOR-based debt instruments, the overarching concern is that, without any relief from the Treasury Department and the Internal Revenue Service (the “IRS”), changing the interest rate on an outstanding debt instrument from IBOR-based to one based on an alternative index could be viewed as a “significant modification” of the IBOR-based debt instrument, which can result in a deemed taxable exchange of the IBOR-based debt instrument for a new debt instrument under Section 1001 of the Code. Similar concerns apply with respect to non-debt contracts that reference an IBOR and whether, without any relief from the Treasury Department and the IRS, the modification of such a contract from one that is IBOR-based to one that is based on an alternative index could be viewed as a taxable exchange of the IBOR-based contract for a new contract under Section 1001 of the Code. 

To a significant extent, the concepts underlying the proposed regulations build upon industry thinking about how to convert from IBORs to a new benchmark, that has been developed to date by the International Swaps and Derivatives Association (“ISDA”) and the Alternative Reference Rates Committee (“ARRC”, a group of private-market participants convened by the Federal Reserve Board and the New York Fed). Both ISDA and ARRC have undertaken extensive work to develop protocols and recommendations for definitions and contractual language that would effect a transition from an IBOR to a new benchmark. Both have endorsed transition in the US to a benchmark based on SOFR. Both ISDA and ARRC have recognized that in order for the transition to be value neutral, when converting to a new benchmark it is necessary to apply a spread adjustment, which would most likely be determined by reference to an averaging of the historic spread between the IBOR being replaced and the new benchmark.

The proposed regulations are generally taxpayer-friendly and have a stated purpose of minimizing potential market disruption and facilitating an orderly transition from IBORs to certain other rates. As is discussed below, and if enacted in their current form, these proposed regulations appear to partially accomplish these stated objectives. However, many uncertainties still remain with respect to certain widely-held debt instruments for which further guidance may be necessary if the stated objectives of the proposed regulations are to be met.

Application of Section 1001 Generally

Section 1001 of the Code provides rules for determining the amount and recognition of gain or loss from the sale or other disposition of property. The regulations under Section 1001 of the Code generally provide that gain or loss is realized upon the exchange of property for other property differing materially either in kind or in extent. In general, in the case of a debt instrument, any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument (that does not otherwise occur pursuant to the terms of such debt instrument) may be treated as a “modification” of such debt instrument. Treasury Regulations generally provide that if a modification of a debt instrument is a “significant modification” of the debt instrument, then such a modification results in a deemed exchange of the original debt instrument for a “new” debt instrument. Changing the interest rate index referenced in a US dollar-denominated debt instrument from USD LIBOR to SOFR if not otherwise pursuant to the terms of the debt instrument is a modification of the debt instrument that could be treated as a significant modification and thus result in a tax realization event, even when USD LIBOR no longer exists. What constitutes a deemed taxable exchange of a non-debt contract under Section 1001 of the Code is a bit less clear under current law, although it is generally believed that absent relief from the Treasury Department and the IRS a change to the terms of a non-debt contract from an IBOR referencing rate to an alternative referencing rate would likely constitute a deemed exchange of the “old” non-debt contract for a “new” non-debt contract, and thus would result in a tax realization event.

The proposed regulations generally provide that, if the terms of a debt instrument are altered or the terms of a non-debt contract, such as a derivative, are modified to replace, or to provide a fallback to, an IBOR-referencing rate and the alteration or modification does not change the fair market value of the debt instrument or non-debt contract or the currency of the reference rate, the alteration or modification does not result in the realization of income, deduction, gain, or loss for purposes of Section 1001 of the Code. The Treasury Department and the IRS intend that these proposed rules apply to both the issuer and holder of a debt instrument, as well as to each party to a non-debt contract. These proposed rules also apply regardless of whether the alteration or modification occurs by an amendment to the terms of the debt instrument or non-debt contract or by an actual exchange of a new debt instrument or non-debt contract for the existing one.

Given that an alteration from an IBOR to a “qualified rate” will almost inevitably be accompanied by certain necessary associated alterations, the proposed regulations make clear that alterations that are both “associated” with and are “reasonably necessary” to adopt the implementation of a replacement of an IBOR, will not be treated as a modification of such instrument. The preamble provides as an example of such permissible alteration the addition of an obligation of a party to make a one-time payment to the other party in connection with the replacement of an IBOR in order to offset the change in value of the instrument that may result from such replacement. 

However, if an alteration is made to an instrument contemporaneously to, but not in connection with, a permitted alteration described above, such contemporaneous alteration is separately tested under existing law in order to determine if the alteration of such instrument results in a deemed exchange for tax purposes. As an example, the proposed regulations provide that if contemporaneous with a change from USD LIBOR to a qualified rate, an interest rate is increased to account for a change in the issuer’s creditworthiness, then whether or not such interest rate change causes a deemed exchange for tax purposes is separately tested under existing law.

The proposed regulations also provide that if a debt instrument is altered to include a qualified rate as a fallback rate, such alteration (and any associated alteration) is not treated as a modification for tax purposes. Similarly, if a non-debt contract is modified to include a qualified rate as a fallback rate, such modification is not treated as an “exchange” for tax purposes. 

Qualified Rates

For a replacement rate to be a “qualified rate” and thus eligible for the favorable treatment discussed above, the rate must be included on the relatively broad list of replacement rates stated in the proposed rule; provided that the rate must satisfy the fair market value and currency requirements discussed below. This list includes (but is not limited to) SOFR, SONIA, TONAR, SARON, CORRA, HONIA, RBA Cash Rate, ESTR, alternative or substitute/successor rates endorsed or recommended by central banks, reserve banks, monetary authorities, or similar institutions, and certain qualified floating rates provided in Treasury regulations. This list also includes rates that are determined by reference to the rates noted in the preceding sentence (such as by adding or subtracting a specified number of basis points).

Most IBORs are term rates, whereas SOFR and many of the other listed benchmarks are overnight rates. Both ISDA and ARRC contemplate that a benchmark used to replace a term IBOR would not be the overnight benchmark itself. Rather, in the US, the replacement benchmark could be term SOFR (a forward looking benchmark derived from future values of SOFR observed in futures or derivatives trading), or compounded or averaged values of SOFR (in advance or in arrears) as published over an observation period. ISDA has endorsed a compounded in arrears approach. Accordingly, we would recommend that the language about rates determined “by reference to” a listed rate be expanded to include various types of term, compounded and averaged rates derived from the listed rates.

Fair Market Value Requirement. A rate is only a “qualified rate” if the fair market value (generally defined as the price at which the instrument would change hands between a willing buyer and willing seller) of the “new” instrument is substantially equivalent to the fair market value of the “old” instrument (the “fair market value equivalence test”). The preamble notes that the fair market value may be difficult to determine precisely, and therefore the fair market value may generally be determined by any reasonable valuation method. The proposed regulations do not provide how close in value the “old” and “new” instrument must be in order to have a “substantially equivalent” value. The proposed regulations do, however, provide for two safe harbors which, if either are met, result in the fair market value equivalence test being satisfied.

The first safe harbor (the “historic average safe harbor”) provides that if the historical average of the relevant IBOR rate and the historical average of the replacement rate do not differ by greater than 25 basis points (after taking into account any spread, one-time payments, or other adjustments made in connection with the alteration), then the fair market value equivalence test is deemed to be satisfied. The proposed regulations state that an historical average may be determined by using an industry-wide standard, such as a method of determining an historical average recommended by ISDA or ARRC for determining a spread adjustment. Alternatively, an historical average may be determined by using any other reasonable method that observes the two rates over a specified period beginning at least 10 years prior to the replacement. 

It is anticipated that ARRC may select or recommend a spread adjustment, or method of determining a spread adjustment, to be used when replacing USD LIBOR with a SOFR based benchmark. It is also anticipated that ISDA may include in its protocols for replacing IBORs with a new benchmark a methodology for determining a spread adjustment, or that ISDA may publish spread adjustments to be used. We would recommend that the historical average safe harbor be clarified, so that it is in all cases met when using a spread adjustment or method of determining a spread adjustment that has been selected or recommended by ARRC or ISDA. The purpose of these spread adjustments is to result in a value neutral conversion to the new benchmark. Taxpayers using a spread adjustment or method of determining a spread adjustment that has been selected or recommended by ARRC or ISDA should not have to independently determine the historical averages of the IBOR rate and the replacement rate.

The second safe harbor (the “arm’s length safe harbor”) generally provides that if (i) parties to an instrument are unrelated and (ii) the parties determine that based on a bona fide, arm’s length negotiation between the parties, the fair market value of the instrument before the alteration is substantially equivalent to the fair market value of the instrument after the alteration (taking into account the value of any one-time payments made in connection with such alteration), then the fair market value equivalence test is deemed to be satisfied. The proposed regulations do not discuss who is a “party” to the instrument for this purpose. 

Currency Requirement. In addition, a replacement rate is only a “qualified rate” if both the IBOR being replaced and the replacement rate are in the same currency.

Real Estate Mortgage Investment Conduits (“REMICs”)

The proposed regulations provide that in general the alteration of a REMIC regular interest from an IBOR to a qualified rate will not violate the REMIC’s fixed terms as of the start-up date requirement, and such alteration will not result in an impermissible contingency with respect to the payments on such REMIC. Further, reasonable costs associated with effecting such alteration paid by the REMIC (or by another party) will not result in an impermissible shortfall to the REMIC (or, if paid by another party, in a prohibited contribution to such REMIC). However, these proposed regulations do not address certain other issues that may arise in the context of a REMIC, some of which were raised in a comment letter submitted by the Structured Finance Association on March 28, 2019 (of which we participated in the drafting). For example, a modification of an underlying mortgage held by a REMIC may be treated as a taxable exchange of such underlying mortgage. A REMIC is, in general, required to have as substantially all of its assets “qualified mortgages.” If a “qualified mortgage” held by a REMIC is deemed to be exchanged for a “new” mortgage loan, the “new” mortgage loan held by the REMIC may not meet the requirements of a “qualified mortgage.” As such, the REMIC’s qualification as such may be at risk. Additional issues may exist in “legacy” RMBS REMICs. For example, it is often the case the “sponsor” or “underwriter” of a legacy RMBS REMIC may no longer exist. As such, it is unclear who would be required to, or entitled to, negotiate the transition from an IBOR-based index to an alternative index.

Other Tax Consequences Addressed

The proposed regulations address the potential impact of these alterations on various other tax provisions as well. For example, the proposed regulations provide that certain “grandfathered” obligations (under, for example, FATCA regulations or under the dividend-equivalent regulations) will not be treated as modified such that they no longer qualify as grandfathered obligations. 

The proposed regulations also provide that in the case of a hedge or an integrated transaction, if one leg of the transaction is altered such that IBOR is replaced with a qualified rate, then in general the underlying hedge or integrated tax treatment will not change, and the taxpayer will not be treated as “legging out” of the transaction. 

Finally, the proposed regulations provide special rules relating to the calculation of original issue discount related to certain variable rate debt instruments, and relating to certain foreign corporation interest expense calculations that previously were able to be calculated based on an average of 30-day LIBOR. 

Effective Date

These proposed regulations generally will become effective once they are published in final form, although taxpayers may generally rely on the proposed regulations currently. Comments and/or requests for a public hearing must be received by November 25, 2019.

Conclusions and Potential Impact of the Proposed regulations

The proposed regulations appear to work in furtherance of their stated purpose without being overly restrictive. They are fairly flexible in their application, allowing parties to replace an IBOR with an otherwise “qualified rate” so long as the fair market values of the “old” and “new” instruments are substantially equivalent. Given that it is also the likely goal of both borrowers and lenders (as well as counterparties in non-debt instruments) to implement a replacement rate without causing a notable deviation in the fair market values of the instruments, these proposed regulations appear to do a good job in allowing flexibility between the parties to alter the instruments as they see fit.

However, while the application of these proposed regulations seems to be relatively straightforward in the case of a loan from “bank X” to “company Y” modified to change the interest rate from an IBOR to a qualified rate, the practical application of these rules is less clear in the situation of an instrument that is held by a multitude of public and/or private investors. For example, in the case of a debt instrument that is widely-held by multiple (and often changing) investors, it is unclear how the parties may use a “consistently applied” valuation method for purposes of the fair market value equivalence test if the parties do not necessarily have the ability to interact with one another. Further, it is unclear how the arm’s length safe harbor may apply if the IBOR replacement terms are set by another party in the transaction (such as an administrator, a servicer or a trustee). It is also unclear if the determination of fair market value for the “old” instrument should include any reduction in the value otherwise attributable solely to the fact that such instrument is IBOR-denominated and does not yet account for a replacement rate. 

The proposed regulations also do not address certain key concerns. For example, and as noted above, although the proposed regulations address changes to the terms of REMIC regular interests, they do not directly address changes to the terms of mortgage loans that make up a REMIC’s collateral. 

In addition, as discussed above, we would recommend that the regulations recognize various types of term, compounded and averaged rates derived from the listed rates, and that the historical average safe harbor be clarified, so that it is in all cases met when using a spread adjustment or method of determining a spread adjustment that has been selected or recommended by ARRC or ISDA.

While the proposed regulations are certainly a great first step in the right direction, further guidance in the final regulations or in the form of a Revenue Procedure is needed to help address some of these uncertainties and unanswered questions.