The IRS and Treasury Department recently released final regulations providing guidance on the modification of debt instruments, derivatives, and other contracts to reflect the transition from the London Interbank Offered Rate (LIBOR) and other interbank offered rates (IBOR) to alternative reference rates. The final regulations generally reflect the fundamental approach of proposed regulations issued in October 2019 allowing taxpayers to modify debt instruments and other contracts to replace IBOR rates with a qualified rate without causing a taxable event. Under existing rules in IRC Section 1001, a change in the terms of a debt instrument or other contract may cause a taxable exchange.

The final regulations contain some modifications to the proposed regulations and differ in structure. In particular, the final regulations:

Under the final regulations, a covered modification is one or more of the following modifications (but not including an excluded modification, see Excluded Modifications):

A covered modification also includes a modification described in Section 4.02 of Revenue Procedure 2020-44 (see Coordination with Revenue Procedure 2020-44).

A contract includes, but is not limited to:

An associated modification is a change of the technical, administrative, or operational terms of a contract that is reasonably necessary to implement a covered modification.

A qualified rate is one of the following rates (provided that the interest rate benchmark to which the rate refers and the discontinued IBOR being replaced are based on transactions in the same currency or are otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency):

The final regulations replace the fair market value requirement of the proposed regulations with a list of modifications excluded from the definition of covered modification. Each of the excluded modifications involves modifying a contract in a way that changes the amount or timing of contractual cash flows. For example, an excluded modification includes a change to the amount or timing of contractual cash flows where the change is intended to compensate one or more parties for a change in rights or obligations not derived from the contract being modified (such as an increase in interest paid to a lender to compensate the lender for changes to customary financial covenants in a way that benefits the borrower).

In 2020 the IRS released Revenue Procedure 2020-44 to provide taxpayer favorable guidance on the adoption of fallback language recommended by the ARRC and the International Swaps and Derivatives Association, effective for contract modifications occurring on or after October 9, 2020 and before January 1, 2023. The final regulations incorporate this guidance by including a modification described in Section 4.02 of Revenue Procedure 2020-44 as a covered modification. A modification described in that section is treated as a covered modification even if the revenue procedure does not apply to the modification (for example, because the modification occurs after December 31, 2022).

The final regulations apply to contract modifications that occur on or after March 7, 2022. However, a taxpayer can apply the final regulations to modifications that occur before March 7, 2022 if the taxpayer and all related parties apply the regulations to all contract modifications occurring before the effective date.