IRS Addresses Tax Questions Raised by Transition from Interbank Offered Rates to Other Reference Rates

In recent months, many in the investment and tax communities have expressed concern over the potential tax consequences of the impending transition to the use of reference interest rates other than interbank rates (“IBORs”) in debt instruments and non-debt contracts. The IRS has just issued proposed regulations that should calm those concerns.

A bit of background may be helpful on what may seem rather esoteric but is in reality hugely important. A vast number of U.S. financial instruments include terms or conditions that reference the London Interbank Offered Rate (“LIBOR”), or more generally IBORs. On July 27, 2017, the UK Financial Conduct Authority, the UK regulator which oversees LIBOR, announced that all currency and term variants of LIBOR, including U.S. dollar LIBOR (“USD LIBOR”), may be phased out after 2021 and not published thereafter. It has been estimated that in 2016 the total exposure to USD LIBOR was close to $200 trillion, of which approximately 95% was in over-the-counter derivatives. USD LIBOR is also referenced in several trillion dollars of corporate loans, floating rate mortgages and similar financial products.

The Alternative Reference Rates Committee (“ARRC”), a group of stakeholders impacted by the elimination of LIBOR, whose ex-officio members include the Board of Governors of the Federal Reserve System, the Treasury Department, the Commodity Futures Trading Commission and the Office of Financial Research, has recommended the so-called Secured Overnight Financing Rate (“SOFR”) as the replacement for USD LIBOR. Since April 3, 2018, the Federal Reserve Bank of New York has published the SOFR daily; there is now trading in SOFR futures, and a number of entities have begun clearing for over-the-counter SOFR swaps. Other countries have adopted or are in the process of selecting a reference rate to replace their respective versions of IBOR.

It is anticipated that most financial products and contracts that contain conditions or legal provisions that rely on LIBOR and IBORs will transition to SOFR or similar alternatives in the next few years. This transition will involve changes to the terms of debt instruments and “non-debt contracts” (such as derivatives, stock, insurance contracts and lease agreements) to adopt SOFR or alternative reference rates.

That brings us to the tax issue. Absent appropriate tax guidance, the concern has been that expected amendments and modifications to these debt instruments and contracts could lead to recognition of gain (or loss) for U.S. income tax purposes and potentially massive tax liabilities for holders. In general, this is not the result desired by the IRS or Treasury, or taxpayers.

Accordingly, the proposed regulations provide that such amendments and modifications to replace a referenced rate based on IBOR with a “qualified rate” (defined in the proposed regulations), or to include a “fallback rate” in anticipation of the elimination of the relevant IBOR, would not result in a tax realization event under IRC Sec. 1001 and relevant related regulations. (According to the preamble to the proposed regulations, a “fallback” provision is a provision specifying what is to occur if an IBOR is permanently discontinued or is judged to have deteriorated to an extent that its relevance as a reliable benchmark has been significantly impaired.) This would apply to both the issuer and holder of a debt instrument and to each party to a non-debt contract. The proposed regulations provide that a qualified rate must be substantially equivalent in fair market value to the replaced rate based on any reasonable, consistently applied method of valuation. Certain safe harbors are provided based on historic average rates and bona fide market value negotiations between unrelated parties.

The proposed regulations also provide corresponding guidance on hedged transactions and derivatives, allowing taxpayers to modify the components of hedged or integrated transactions to replace IBORs with qualified rates without affecting the tax treatment of the hedges or underlying transactions.

Rules are also applied for determining the amount and accrual of original issue discount (“OID”) in the case of certain variable rate debt instruments and for REMICs.

Comments on the proposed regulations are requested.

While various effective dates apply, these regulations would generally apply to alterations or modifications to the terms of debt instruments or non-debt contracts occurring on or after the adoption of final regulations, though a taxpayer may choose to apply the regulations earlier if consistently applied. Similarly, new OID rules would apply to affected debt instruments issued on or after the adoption of final regulations, subject to taxpayers’ early application of these rules.