The Internal Revenue Service (IRS) has issued Revenue Procedure 2020-44 (the Revenue Procedure) providing interim guidance for taxpayers moving away from Interbank Offered Rates (IBORs) to fallback provisions issued by the Alternative Reference Rates Committee (ARRC) or the International Swaps and Derivatives Association (ISDA). Here is why the guidance, though fairly constrained, is welcome news for several reasons.
A vast number of financial instruments, including adjustable rate mortgages, bilateral business loans, floating rate notes, securitizations, syndicated loans, and variable-rate private student loans, as well as derivatives and swaps, utilize some form of an IBOR, often the London Interbank Offered Rate (LIBOR) or one of its currency variants, such as US-dollar LIBOR (USD LIBOR), to calculate payments under the instrument.
For the last several years, the financial community has been adapting to the 2017 decision by the Financial Conduct Authority, the UK regulator tasked with overseeing LIBOR, to phase out all currency and term variants of LIBOR, including USD LIBOR, after the end of 2021. The ARRC was convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York to identify an alternative reference rate. After considering a comprehensive list of alternatives, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR, and since April 3, 2018, the Federal Reserve Bank of New York has published SOFR daily.
To support the transition from USD LIBOR, the ARRC has published recommended fallback language for inclusion in the terms of newly issued financial products that provide a mechanism for determining a replacement benchmark rate in the event that the current benchmark rate (such as USD LIBOR) is replaced. The fallback language generally also provides a mechanism for determining a spread adjustment that is added to the replacement benchmark rate to account for any difference between the replacement benchmark rate and the current benchmark rate. Although the ARRC has recommended this fallback language for use in newly issued financial instruments, holders of outstanding instruments that reference USD LIBOR may also modify the terms of those instruments to incorporate the appropriate fallback language.
In the derivative space, documents published by the International Swaps and Derivatives Association (ISDA), such as the 2002 ISDA Master Agreement and the 2006 ISDA Definitions, form the basic framework of many derivative contracts, including through the provision of various rate options that parties may choose from to determine an overall floating rate applicable to the contract, and fallback provisions that generally designate another rate to stand in for a relevant IBOR if the IBOR is unavailable.
ISDA posted Supplement number 70 to the 2006 ISDA Definitions on its website on October 9, 2020, (ISDA Supplement) to facilitate the inclusion of new fallbacks for certain key IBORs in derivatives transactions entered into on or after the date the ISDA Supplement takes effect. The ISDA Supplement has a final date of October 23, 2020, and a publication and effectiveness date of January 25, 2021. Among other things, the ISDA Supplement amends the fallback provisions for rate options that refer to IBORs to provide that, upon the occurrence of certain events, a substitute rate identified in the ISDA Supplement replaces the relevant IBOR.
Derivative contracts entered into on or after the effective date of the ISDA Supplement will generally include the relevant terms of the 2006 ISDA Definitions as amended by the ISDA Supplement. However, the terms of derivative contracts entered into prior to the effective date of the ISDA Supplement (legacy derivative contracts) will not incorporate the terms of the ISDA Supplement. To facilitate adoption of the ISDA Supplement by parties to legacy derivative contracts, ISDA posted the final ISDA 2020 IBOR Fallbacks Protocol on October 9, 2020, (ISDA Protocol). The ISDA Protocol will launch publicly on October 23, 2020. If parties adhere to the ISDA Protocol, all covered derivative contracts between those parties are generally modified to incorporate the terms of the ISDA Supplement or, in some cases, to incorporate a version of the terms of the ISDA Supplement adapted to fit the existing terms of the contract.
Tax Issues
For newly issued instruments and financial contracts that incorporate the ARRC fallback language or the terms of the ISDA Supplement, a change to a substitute reference rate after the replacement or invalidity of the existing reference rate should not result in material tax consequences for the issuer or holder of the instrument. For US federal income tax purposes, the alteration of a debt instrument pursuant to its original terms typically does not rise to the level of a “significant modification” that would result in a deemed exchange of that instrument.
However, where an existing instrument or contract is modified, either to add terms relevant to the replacement of a benchmark rate, or to actually replace that rate in the event of its obsolescence, unavailability or invalidity, the modification would not be pursuant to the original terms of the instrument. Accordingly, Treasury Regulations Section 1.1001-3 generally would require that the relevant modification be analyzed to determine whether it is a “significant” modification. That modification could be viewed as resulting in a deemed exchange of the instrument for US federal income tax purposes. This could result in the recognition of gain or loss by issuers or holders, a redetermination of the existence or extent of original issue discount (OID) on the instrument, a new analysis of the instrument’s qualification as a valid hedge, and various other potentially adverse consequences.
On October 8, 2019, the IRS and the US Treasury Department (Treasury) released proposed regulations (the Proposed Regulations) addressing some of the potential tax consequences associated with taxpayers moving away from an IBOR-referencing rate, such as USD LIBOR, to a different reference rate.[1] In particular, the Proposed Regulations provided that “fallback provisions,” which replace an IBOR-referencing rate with certain “qualified rates,” do not constitute a “significant modification” that result in an exchange of the debt instrument for purposes of Section 1.1001–3 of the Treasury Regulations. Without this guidance, a change in the reference rate could result in the imposition of taxes, which could impair the ability of the issuer of the debt instrument to make payments to investors or, in the case of a note with a LIBOR-based rate, could result in an investor being required to currently recognize gain or loss.
In a March 12, 2020 letter, the ARRC suggested amendments to, and requested guidance about, Section 1.1001-6 of the Proposed Regulations, including revising the definition of “qualified rates” to permit fallbacks to ARRC fallback provisions, ISDA fallback provisions, and provisions substantially similar to ARRC and ISDA fallback provisions. The ARRC argued that including these fallback provisions would help provide certainty to investors and increase market stability and would be consistent with the Treasury’s intent behind Section 1.1001-6 of the Proposed Regulations, but that it was not clear under the language of the Proposed Regulations whether such fallback provisions were permitted.
In response, on October 9, 2020 the IRS issued the Revenue Procedure, which provides that modifications to “contracts”[2] to replace an IBOR-referencing rate with an ARRC fallback provision (an ARRC Fallback), an ISDA fallback provision (ISDA Fallback), or certain similar fallback provisions with specified deviations from ARRC or ISDA fallback provisions would not result in a “significant modification.”[3] In addition, replacing an IBOR-referencing rate with a fallback rate permitted by the Revenue Procedure is not treated as legging out of an integrated transaction under Section 1.1275-6 or Section 1.988-5(a) of the Treasury Regulations, terminating a qualified hedge under Section 1.148-4(h) of the Treasury Regulations, or disposing or terminating either leg of a transaction under Section 1.446-4 of the Treasury Regulations.[4] These Treasury Regulations, however, do apply to the extent a modification not permitted by the Revenue Procedure is taken contemporaneously with a modification that is permitted by the Revenue Procedure.[5]
An ARRC Fallback is contract language both (i) recommended by the ARRC, and (ii) one of the types specifically identified in the Revenue Procedure.[6] An ISDA Fallback is one of a specific set of provisions identified in the ISDA Protocol.[7] Certain deviations from the terms of an ARRC Fallback or ISDA Fallback are permitted, however, including (among others) to comply with law or to account for specific deal terms.
Rather than amending the definition of “qualified rate” from the Proposed Regulations or directly addressing whether ARRC Fallbacks or ISDA Fallbacks are qualified rates, the Revenue Procedure instead simply concludes that modifying an IBOR-referencing rate consistent with the Revenue Procedure is not treated as a transaction that triggers a tax event.
The Revenue Procedure is effective for modifications to contracts occurring on or after the date of the Revenue Procedure (October 9, 2020) and before January 1, 2023, but taxpayers may rely on the Revenue Procedure for modifications occurring before October 9, 2020.[8] This retroactive effect is significant because some structured finance offerings have already been modified to add fallback provisions with ARRC or ISDA language. The Revenue Procedure permits these prior modifications so long as the language regarding the replacement rate qualifies under the Revenue Procedure.
The guidance provided by the Revenue Procedure is welcome for multiple reasons. Financial instruments and contracts that initially are entered into with ARRC fallback provisions, in conformity with the ISDA Protocol, or the ISDA Supplement, will have certainty that a switch from an IBOR rate, such as USD LIBOR, to a fallback rate pursuant to the terms of the relevant fallback provisions will not have unwelcome US federal income tax consequences. Many contracts entered into in the past year have included some version of the ARRC fallback provisions, in reliance on the hope that the IRS would not view changes to a benchmark rate pursuant to those provisions as constituting a deemed exchange of the instrument. With the pre-October 9, 2020 “grandfathering” language of the Revenue Procedure, that hope has been vindicated.
However, the guidance is also fairly constrained. The beneficial treatment is limited to financial instruments and contracts that adhere closely with the ARRC fallback language or the ISDA fallback language in specific circumstances explicitly referenced in the Revenue Procedure, and excludes other circumstances, even if those circumstances are elsewhere recommended by the ARRC. The IRS has provided a set of permitted deviations from the approved language, but that set is finite, small, and specific. The IRS indicated that the Treasury and the IRS may provide additional relief as necessary to address developments in the transition away from IBORs. For example, if the ARRC modifies the specified contract language identified in the Revenue Procedure or recommends similar contract language for inclusion in other cash products after October 9, 2020, the Treasury and the IRS will evaluate the ARRC’s new or revised contract language and may supplement the definition of an ARRC fallback accordingly.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
Katherine Dobson Buckley
New York
Charles R. Bogle
Thomas V. D’Ambrosio
Ester Lee
Sarah A. Nelson
Washington, DC
Richard C. LaFalce
Charles A. Sweet
[1] Read our prior LawFlash for further discussion of the Proposed Regulations.
[2] A “contract” includes a derivative contract, a debt instrument, stock, an insurance contract, and a lease agreement. Revenue Procedure, Section 4.01.
[3] Revenue Procedure, Sections 4.01, 4.02, 5.01.
[4] Revenue Procedure, Section 5.02.
[5] Revenue Procedure, Section 5.03.
[6] Revenue Procedure, Section 3.01.
[7] Revenue Procedure, Section 3.02.
[8] Revenue Procedure, Section 6.