The Internal Revenue Service (IRS) and the US Treasury Department (Treasury) have issued proposed regulations under Sections 860G, 882, 1001, and 1275 providing rules for taxpayers moving away from interbank offered rates (IBORs) to other reference rates. This is the first time the IRS has promulgated specific rules under Section 1001 and related regulations to nondebt financial instruments. The proposed regulations provide much needed clarity and tax relief for financial institutions, counterparties, and investors transitioning to alternative reference rates, although the full scope of alternative reference rates is still developing.
IBORs, such as the London interbank offered rate (LIBOR), set benchmark rates for unsecured lending for various financial instruments. The US-dollar LIBOR (USD LIBOR) is especially prevalent for US financial institutions. In 2017, the UK Financial Conduct Authority, the entity that oversees LIBOR, announced that LIBOR, including USD LIBOR, may be phased out at the end of 2021. The United States and other countries have been in the process of identifying alternative reference rates.
On October 8, 2019, the IRS and the Treasury released proposed regulations (the Proposed Regulations) addressing various potential tax consequences in connection with taxpayers moving away from an IBOR-referencing rate, such as USD LIBOR, to a different reference rate. Under current law, changing the reference rate (and associated alterations or modifications, such as adjusting the spread or making a one-time payment to account for different reference rates)
These Proposed Regulations would be effective for taxable years ending after the date of publication of final regulations in the Federal Register. Taxpayers, however, may rely on the Proposed Regulations before publication of final regulations.[1]
The Proposed Regulations change the tax treatment in the following ways.
Under the Proposed Regulations, changing the reference rate of either a debt instrument or an NDC[2] does not trigger gain or loss under Section 1001 of the Code for counterparties so long as (i) the alteration or modification does not change the fair market value (FMV)[3] of the instrument or NDC, or change the currency of the reference rate, and (ii) the new reference rate is a “qualified” rate, which includes a rate endorsed by a bank.[4]
The Proposed Regulations also cover associated alterations (relating to debt instruments) and associated modifications (relating to NDCs) reasonably necessary to adopt the new reference rate, such as a one-time payment.[5] The source and character of such a one-time payment is the same as a payment made with respect to the modified debt instrument or NDC.[6]
If these requirements are satisfied, altering or modifying the reference rate from an IBOR-referencing rate to a qualified rate also does not give rise to: (a) a legging out of an integrated hedge transaction; (b) a disposition or termination of either leg in a hedge transaction; (c) a termination of a qualified hedge (with respect to tax-advantaged bonds); or (d) a debt instrument or NDC losing its grandfathered status for FATCA purposes.[7]
So long as the debt instrument has a variable rate and provides both an IBOR-referencing rate and a mechanism to change to an alternative reference rate (the fallback rate),[8] the Proposed Regulations deem that the possibility of IBOR becoming unavailable or unreliable is remote.[9]
Additionally, the IBOR-referencing rate and the alternative rate are treated as a single rate for purposes of the VRDI rules,[10] and the change to the alternative rate is not treated as a change in circumstances under the rules governing subsequent adjustments for remote contingencies actually occurring.[11]
Thus, under the Proposed Regulations a debt instrument currently treated as a VRDI will not become a CPDI upon a permissible change in rate.
The Proposed Regulations disregard changes from an IBOR-referencing rate to an alternative rate after the startup date of a REMIC for purposes of determining whether an interest qualifies as a regular interest in a REMIC.[12] Similarly, a REMIC interest does not fail to qualify as a regular interest in a REMIC solely because it either adopts a fallback rate or because the REMIC incurs reasonable expenses connected to changing to the fallback rate, even if a party other than the REMIC pays the expenses.[13]
The Proposed Regulations permit foreign banks to elect to use the Secured Overnight Financing Rate (SOFR), which the Federal Reserve Bank of New York calculates based on overnight transactions, and the IRS and Treasury in the preamble request comments on other acceptable rates.[14]
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:
New York
Chuck Bogle
Sarah Nelson
Richard Zarin
Washington, DC
Richard C. LaFalce
[1] See Prop. Reg. § 1.1001-6(g). This also applies to related parties, within the meaning of Sections 267(b) and 707(b)(1), so long as the taxpayer and related parties consistently apply the rules.
[2] An NDC is an instrument such as a derivative, stock, an insurance contract, or a lease agreement.
[3] Fair market value may be determined by any reasonable valuation method applied consistently and takes into account any one-time payments. This value equivalence test is deemed satisfied if either of two safe harbors are satisfied: (1) the historic average of the IBOR-referencing rate, using an appropriate look-back period and methodology, is within 25 basis points of the new reference rate; or (2) the parties to the debt instrument or NDC are not related and conclude, after arm’s-length negotiation, that the FMV with the new reference rate, including any changes to the spread or one-time payments, is substantially equivalent to the FMV with the IBOR-referencing rate. See Prop. Reg. § 1.1001-6(b).
[4] See Prop. Reg. § 1.1001-6(a), (b).
[5] See Prop. Reg. § 1.1001-6(a)(5).
[6] See Prop. Reg. § 1.1001-6(d).
[7] See Prop. Reg. § 1.1001-6(c), (e).
[8] Altering the terms of a debt instrument to include or substitute a qualified alternative rate does not trigger Section 1001. See Prop. Reg. § 1.1001-3.
[9] See Prop. Reg. § 1.1275-2(m)(3).
[10] See Prop. Reg. § 1.1275-2(m)(2).
[11] See Prop. Reg. § 1.1275-2(m)(4).
[12] See Prop. Reg. § 1.860G-1(e)(2).
[13] See Prop. Reg. § 1.860G-1(e)(3), (4).
[14] See Prop. Reg. § 1.882-5(d)(5)(ii)(B).