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January 10, 2022
US | Final rules address tax consequences of transitioning from the use of LIBOR and other interbank offered rates in certain financial contracts
In final regulations (TD 9961) (the Final Regulations) released 30 December 2021, the United States (US) Treasury Department provided guidance on the elimination of, and pending transition from, the use of certain interbank offered rates (IBOR), including the London interbank offered rate (LIBOR), in certain financial contracts, including debt instruments, derivatives and other contracts. The Final Regulations address whether a modification of the terms of a contract to replace an existing IBOR with a new reference rate results in a taxable event and the realization of income, deduction, gain, or loss.
The Final Regulations adopt, with certain changes, proposed regulations issued by the Treasury Department on 9 October 2019 (the Proposed Regulations). They also incorporate, where relevant, additional guidance on adding recommended fallback language to certain financial contracts, as outlined in Revenue Procedure 2020-44 on 9 October 2020. Prior Alerts provide additional background on the pending elimination of IBORs, including US dollar LIBOR (USD LIBOR), as well as details on the Proposed Regulations, Revenue Procedure 2020-44 and the US federal income tax rules implicated by the transition from IBORs (see EY Global Tax Alerts, US IRS issues proposed rules addressing tax consequences of elimination of LIBOR and other interbank offered rates, dated 11 October 2019 and US IRS confirms that some modifications to debt instruments and other contracts to reflect LIBOR discontinuation will not result in a deemed taxable exchange, dated 20 October 2020.
All currency and term variants of LIBOR (with the exception of certain USD LIBOR tenors, and certain "synthetic" British sterling and Japanese yen LIBORs) ceased to be published immediately after 31 December 2021. The publication of the overnight, 1-month, 3-month, 6-month, and 12-month USD LIBOR is scheduled to cease immediately after 30 June 2023; the publication of these "synthetic" LIBORs will continue until the end of 2022.
The Final Regulations are generally consistent with the Proposed Regulations but differ significantly in structure. They also simplify the operative rules. For example, the Proposed Regulations separately stated rules applicable to debt and non-debt contracts, whereas the Final Regulations contain a broad definition of a "contract," which includes not only debt and derivative instruments, but also insurance contracts, stock, leases and other contractual relationships. In addition, the Final Regulations use certain defined terms to streamline references to concepts frequently used in the operative rules. The term "covered modification" is the cornerstone of these rules and serves to restructure several of the fundamental rules in the Proposed Regulations.
In one significant substantive change from the Proposed Regulations, the Final Regulations replace the fair market value requirement under the Proposed Regulations with rules that exclude specific modifications (excluded modifications) from the definition of a covered modification.
The Final Regulations, principally contained in Treas. Reg. Section 1.1001-6, apply to any contract modification occurring on or after 7 March 2022. A taxpayer may choose to apply the Final Regulations to contract modifications occurring before the applicability date, provided that the taxpayer and all related parties (within the meaning of Internal Revenue Code1 Sections 267(b) or 707(b)(1)) apply the Final Regulations to all contract modifications occurring before that date.
This Alert describes the key changes made to the Proposed Regulations by the Final Regulations, with a specific focus on the rules applicable under Treas. Reg. Section 1.1001-6.
Prop. Reg. Section 1.1001-6(a) generally did not treat certain modifications of debt instruments as modifications for purposes of Section 1001, and did not treat certain modifications of non-debt contracts as exchanges of property for other property under Treas. Reg. Section 1.1001-1(a). These types of modifications generally involved replacing an IBOR-based rate (or IBOR-based fallback provisions), or adding or amending a fallback provision that would replace IBOR-based rates. The Proposed Regulations extended this treatment to any reasonably necessary conforming modifications (associated modifications). The Final Regulations provide similar rules, but use the defined terms "covered modification" and "noncovered modification."
Treas. Reg. Section 1.1001-6(b)(1) does not treat a covered modification as an exchange of property differing materially in kind or in extent for purposes of Treas. Reg. Section 1.1001-1(a) (e.g., the modification is not a significant modification of a debt instrument under Treas. Reg. Section 1.1001-3).2 A covered modification is any modification (regardless of its form and whether it is evidenced by express agreement (written or oral), conduct of the parties or otherwise) that modifies the contract to:
The broad definition of "modification" in the Final Regulations permits the complete replacement of an existing contract with a new contract (e.g., the termination of a LIBOR contract and replacement with a new contract referencing a qualified rate) to be classified as a "covered modification."
A covered modification also includes a modification described in section 4.02 of Revenue Procedure 2020-44, as supplemented by any additional guidance that may be published in the Internal Revenue Bulletin. Any modification that is not a covered modification or an associated modification is a "noncovered modification," which is subject to the general rules under Section 1001 and its regulations (including the significant modification rules of Treas. Reg. Section 1.1001-3).
The Final Regulations introduce the term "discontinued IBOR," which is not used in the Proposed Regulations, and is generally an IBOR that is scheduled to be discontinued. An IBOR generally becomes a discontinued IBOR when its administrator announces that it will cease to provide the IBOR permanently or indefinitely. The rate ceases to be a discontinued IBOR one year after the administrator ceases to provide the IBOR. According to the Preamble, the purpose of the new definition is to tailor the relief in the Final Regulations to better match the problem that they are intended to address: the facilitation of the transition from discontinued IBORs to avoid the market disruption that may occur if parties to contracts referencing discontinued IBORs fail to transition before the discontinued IBOR ceases.
Qualified one-time payments
The Proposed Regulations include certain one-time payments as an "associated modification." To improve readability and clarity, the Final Regulations contain a standalone defined term, "qualified one-time payment." In response to public comments citing potential abuses that may result if the one-time payment is not limited in some way, the Final Regulations cap a qualified one-time payment at the amount intended to compensate for the basis difference between the discontinued IBOR and the new rate. An amount over the cap is a noncovered modification tested under the general rules of Section 1001.
The Proposed Regulations treated the character and source of a qualified one-time payment the same as a payment under that contract by that payor (e.g., a one-time payment by a lessee on a lease is characterized as a payment of rent and sourced accordingly). Comments requested clarification on how the rule applied to several financial contracts, as well as the timing of items associated with the one-time payment. The Final Regulations do not provide additional guidance; Treasury and the Internal Revenue Service (IRS) continue to study how best to address these issues. The Preamble allows taxpayers to rely on the Proposed Regulations to determine the source and character of qualified one-time payments under the Final Regulations, but the Proposed Regulations do not provide any guidance on timing issues.
Qualified rates and excluded modifications
The Proposed Regulations contained a list of potential qualified rates, including the Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (SOFR), the Sterling Overnight Index Average (SONIA), and the Swiss Average Rate Overnight (SARON). In response to comments, the Final Regulations merge the rates described in Prop. Reg. Section 1.1001-6(b)(1)(i) through (viii) and (x) into a single, non-exhaustive list of rates that are generally qualified floating rates. If it cannot be determined at the time that a fallback rate is added to a contract that the fallback rate would qualify as a qualified rate, the rate does not constitute a fallback rate; as such, the modification would not constitute a covered modification. In addition, the Final Regulations authorize the Alternative Reference Rates Committee (ARRC) to identify additional qualified rates, but only as long as the Federal Reserve Bank of New York continues to be an ex officio member of the AARC. The Final Regulations also authorize the IRS to identify additional qualified rates in future published guidance.
Commenters questioned how the definition of qualified rate applies when a contract is modified to include a waterfall of fallback rates and the individual tiers do not independently satisfy the definition of a qualified rate (for example, the first tier of the waterfall replaces USD LIBOR when it ceases, and a second tier replaces the first tier if it ceases). The Final Regulations allow a single qualified rate to comprise more than one fallback rate, such as when parties add a fallback waterfall. This rule effectively treats a waterfall of fallback provisions as a unit, and evaluates that unit to determine if it is a qualified rate. The collection of fallback rates, however, is treated as a qualified rate only if each individual fallback rate meets the definition of a qualified rate. For these purposes, a fallback rate does not meet the definition of a qualified rate if the contract's terms do not ensure that the fallback rate will meet the requirements for a qualified rate at the time of the modification. If the likelihood of a fallback rate being triggered is remote, however, the fallback rate is treated as meeting those requirements. The Final Regulations provide a series of examples illustrating these concepts.
Finally, in response to public comments, the Final Regulations eliminate the fair market value equivalence test described in the Proposed Regulations. That test required, as a condition of satisfying the definition of qualified rate, the fair market value of the debt or non-debt contract after the relevant alteration or modification to be substantially equivalent to the fair market value before that alteration or modification. In place of the fair market value equivalence test, the Final Regulations treat modifications that are not a necessary component of the covered modification or otherwise described in the Final Regulations as noncovered modifications that must be tested under the general rules of Section 1001. According to the Preamble, using the excluded modification framework is consistent with the purpose of the fair market value equivalence test, which was to ensure that modifications to the cash flows of an IBOR-referencing contract address the replacement rate in the contract. Excluded modifications are those that change the amount or timing of contractual cash flows and are intended to:
A series of examples illustrates the application of the excluded modifications. The Final Regulations also authorize the IRS to identify additional modifications to contractual cash flows as excluded modifications if the modification has a principal purpose of achieving a result that is unreasonable in light of the provision's purpose. They do not, however, outline additional guidance on the types of modifications that the IRS may identify. Any excluded modifications identified in future guidance would apply prospectively.
Integrated transactions and hedging transactions
The Proposed Regulations allowed taxpayers to modify debt instruments and/or associated derivatives that are integrated under Treas. Reg. Sections 1.1275-6 and 1.988-5 without disrupting integrated treatment (i.e. a legging out of integrated treatment), provided the transaction continued to qualify for integration after the modification. The Proposed Regulations did not, however, include rules on contract modifications that add or amend fallback provisions. In response to public comments, the Final Regulations treat the addition of a new, or amendment of an existing, fallback provision as a covered modification. Thus, the modification generally is not treated as a legging out of an integrated transaction. The Preamble cautions, however, that the triggering of a fallback provision may result in a legging out of integrated treatment to the extent of any mismatch in the fallback provisions and the components of the integrated transaction.
In addition, the Final Regulations introduce a 90-day grace period under which taxpayers can maintain integrated treatment despite minor mismatches between the modified terms of the components of an integrated transaction. If, however, the transaction fails to qualify for integrated treatment at the end of the 90-day period beginning on the date of the first covered modification of any component of the integrated transaction, the covered modification will be treated as a legging out as of the date of the first covered modification. The Final Regulations also permit taxpayers to enter into temporary hedging transactions to manage any economic risk arising from these temporary mismatches, and to integrate such temporary hedges during the 90-day grace period, without causing a legging out of integrated treatment.
Interest expense of a foreign corporation
The Proposed Regulations allowed foreign corporations that are banks to elect to compute interest expense attributable to excess US-connected liabilities using a yearly average of SOFR rather than the 30-day USD LIBOR permitted under existing rules. One comment noted that the yearly average SOFR is not a proper substitute for 30-day USD LIBOR, and recommended the Final Regulations either refer to a widely accepted interest rate benchmark more similar to 30-day USD LIBOR or add a fixed spread to the yearly average SOFR.
The Final Regulations did not adopt this comment, but the Preamble states the Treasury and IRS will continue to study the appropriate rate to replace 30-day USD LIBOR. In doing so, the Preamble states, Treasury and the IRS will balance the administrative convenience of providing taxpayers an election to use a published rate against the necessity of ensuring that the replacement rate more accurately reflects the taxpayer's borrowing costs. Until final regulations are published, however, taxpayers may continue applying the general rule or the annual published rate election provided under Treas. Reg. Section 1.882-5(d)(5)(ii); alternatively, taxpayers may rely on the Proposed Regulations to use the yearly average SOFR. The Preamble to the Final Regulations requests recommendations for a specific rate that would be an appropriate substitute and indicates that Treasury and the IRS anticipate issuing additional guidance before the 30-day USD LIBOR is discontinued in 2023.
The Final Regulations provide much-needed final guidance and clarity on most issues regarding the transition from and elimination of IBORs, including USD LIBOR. Despite the substantive structural changes to the rules, the thrust of the Final Regulations is generally consistent with the guidance issued in the Proposed Regulations and Revenue Procedure 2020-44. As a result, taxpayers that have previously identified and modified IBOR-related contracts while adhering to that guidance may be able to retroactively apply the Final Regulations without adverse US tax consequences, as long as they apply the rules consistently.
In addition, the Final Regulations provide comfort around integrated transactions, alleviating substantial concerns that modifications (in particular those that amend or add fallback provisions) to ease the transition from IBORs would lead to a legging out of integrated treatment. The elimination of the fair market value equivalence rule may also lead to greater certainty in the US federal income tax consequences of any modifications to IBOR-related contracts. However, the Final Regulations treatment of fees intended to induce parties to consent to covered modifications as being separate noncovered modifications seems inconsistent with the overall policy of facilitating parties' elimination of LIBOR. Nevertheless, this treatment will not have an impact in many instances because the amount of the consent fee is unlikely to trigger a Section 1001 exchange on a stand-alone basis.
The Final Regulations leave several questions unanswered, including the treatment of qualified one-time payments. In particular, the timing of a qualified one-time payment on a debt instrument may concern affected taxpayers. While taxpayers may continue to rely on the Proposed Regulations for these issues, many were not addressed by the Proposed Regulations in the first instance. As a result, taxpayers may continue grappling with such issues until further guidance is issued. Nonetheless, taxpayers are encouraged to identify any remaining IBOR-based instruments and modify those instruments to transition from IBOR, in accordance with the Final Regulations.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transaction Services
Ernst & Young LLP (United States), International Tax and Transaction Services, Capital Markets
Ernst & Young LLP (United States), Financial Services Office