IRS and Treasury Provide Tax Relief for LIBOR Replacement | Practical Law

IRS and Treasury Provide Tax Relief for LIBOR Replacement | Practical Law

On October 8, 2019, the IRS and Treasury Department released guidance providing tax relief to taxpayers who modify debt instruments and derivatives to reflect the anticipated phaseout of the London Interbank Offered Rate after 2021.

IRS and Treasury Provide Tax Relief for LIBOR Replacement

Practical Law Legal Update w-022-4235 (Approx. 5 pages)

IRS and Treasury Provide Tax Relief for LIBOR Replacement

by Practical Law Finance
Published on 11 Oct 2019 • USA (National/Federal)
On October 8, 2019, the IRS and Treasury Department released guidance providing tax relief to taxpayers who modify debt instruments and derivatives to reflect the anticipated phaseout of the London Interbank Offered Rate after 2021.
The IRS and Treasury Department recently issued proposed regulations providing tax relief to taxpayers who modify debt instruments and derivatives to reflect the anticipated discontinuance of the London Interbank Offered Rate (LIBOR) after 2021. LIBOR is an interest rate benchmark used as a reference rate for a wide range of financial transactions, including derivatives and loans to companies, consumers, and governments. It is intended to reflect the average rate at which major banks can obtain unsecured funding in the London interbank market in a specified currency and particular period. Following several investigations of banks for manipulating LIBOR, in 2017 the UK's Financial Conduct Authority, which oversees LIBOR, announced the phaseout of LIBOR by the end of 2021.
The Alternative Reference Rate Committee (ARRC) has recommended replacing USD LIBOR with the Secured Overnight Financing Rate (SOFR). Other jurisdictions are also working to transition to non-LIBOR reference rates in their respective currencies.
The proposed regulations primarily address the consequences of altering debt instruments and derivatives to replace a rate referencing LIBOR (or another interbank offered rate (IBOR)) or to add or substitute a rate as a fallback to an IBOR-referencing rate. Under existing rules, a change in a debt instrument that is a "significant modification" causes a deemed taxable exchange of the debt instrument for tax purposes. Under the proposed regulations, a taxable event does not occur on the modification of a debt instrument or derivative to replace an IBOR-referencing rate with a qualified rate or to include or substitute a qualified rate as a fallback to an IBOR-referencing rate if both:
  • The fair market value of the debt instrument or derivative after the modification is substantially equivalent to the fair market value of the debt instrument or derivative before the modification.
  • The modification does not change the currency of the reference rate.
Qualified rates are listed in the proposed regulations, and include SOFR. Modifications covered by the guidance include one-time payments made in connection with replacing an IBOR-referencing rate.
Under a safe harbor, the fair market valuation requirement is met if either:
  • On the date of the modification, the historic average of the relevant IBOR-referencing rate does not differ by more than 25 basis points from the historic average of the replacement rate:
    • taking into account any spread or other adjustment to the rate; and
    • adjusted to take into account the value of any one-time payment made in connection with the modification.
  • The parties to the debt instrument or derivative are not related and the parties determine based on bona fide, arm's length negotiations that the fair market value of the debt instrument or derivative before the modification is substantially equivalent to the fair market value after the modification (taking into account the value of any one-time payment made in connection with the modification).
The proposed regulations also clarify that a qualifying LIBOR modification will not cause a debt instrument or derivative to lose its grandfathered status for FATCA withholding tax purposes. For more information on grandfathered obligations under FATCA, see Practice Note, FATCA Withholding: Withholding Exception for Grandfathered Obligations.
The proposed regulations are proposed to apply to modifications of debt instruments and derivatives that occur on or after the date the regulations are finalized. However, a taxpayer can rely on the proposed regulations for modifications before that date if the taxpayer and related parties consistently apply the proposed rules.