United States: Moving On From LIBOR

The IRS has issued proposed regulations that allow issuers to replace LIBOR rates associated with their bonds and swaps without triggering a reissuance of the bonds or a deemed termination of the swaps. The replacement rate must be a "qualified rate," which includes the Secured Overnight Financing Rate (“SOFR”). A rate isn't a "qualified rate" unless the fair market value of the bond or swap is the same before and after the replacement, taking into account any one-time payment made in connection with the switch. Although they're only proposed regulations, issuers can apply them immediately.

Background – Once again, let us dazzle you with the most boring part of a very interesting topic.

Countless municipal bonds and countless derivatives1 that relate to those bonds depend on the continued existence of one or more of the London Interbank Offered Rates, which are referred to generically as "LIBOR."2 In particular, many variable rate bond documents contain rates that are based on LIBOR, and many derivatives contain a variable stream of payments or receipts that is based on LIBOR. For municipal bonds that bear interest at a rate that is based on LIBOR, if LIBOR can't be determined, then in most cases the bond documents will move the interest rate on the bonds into a "fallback" rate that could be very financially unattractive for the issuer. The same could be true for an interest rate swap with a stream of payments or receipts that is based on LIBOR.

The U.K. Financial Conduct Authority, which oversees3 LIBOR, told the world in the summer of 2017 that LIBOR likely will be gone some time after the end of 2021. Seeking to avoid the heartache that would befall their bonds and swaps that depend on LIBOR, many issuers of municipal bonds want to cut out the LIBOR provisions4 from their bonds and swaps wherever the acronym appears.

The skullduggery and palace intrigue surrounding the LIBOR manipulation scandal (which was no doubt one of the reasons for the LIBOR phaseout) have been described comprehensively. (It is a topic far too interesting and salacious for our humble blog.) The economic considerations behind switching indices are also an interesting topic. But we are here for a different question – any time that an issuer takes the surgeon's scalpel to its bond or swap documents to remove references to LIBOR, the issuer must consider whether the changes cause the bonds or swaps to be "reissued" for tax purposes.

The point of the reissuance rules is that when parties start making changes to a debt, at some point the changes are so significant that the modified debt is tantamount to the actual issuance of a new debt to refinance the old debt. Under our tax system, this means a reckoning of gains or losses for the holder and issuer of the debt, but, more importantly for tax-exempt bond purposes, it means that the modified debt is treated as a new issue of debt that currently refunds the unmodified debt. This can lead to negative consequences, such as changes in yield, the requirement to make a rebate payment (because the deemed refunded debt is treated as retired, triggering the requirement for a final rebate payment), and the risk that the tax law will have changed since the issuance of the original bonds in a way that causes different, more restrictive rules to apply to the deemed refunding bonds.5

An issuer that wants to replace LIBOR in its documents probably doesn't intend for the replacement of LIBOR with a new rate to be an economically significant change. (The issuer might take the opportunity to revisit other aspects of the deal and make changes to those aspects that are economically significant, but the specific replacement of LIBOR likely isn't intended to be.) The phaseout of LIBOR doesn't affect what the parties wanted their economic bargain to be when they struck it; LIBOR merely was the benchmark providing the reference point for that bargain. Thus, it would be sensible to have a rule saying that the replacement of LIBOR with another index isn't the sort of modification that would be so fundamental that it would be treated as a deemed exchange of the unmodified instrument for the modified instrument.

The IRS has given us that rule in these proposed regulations (specifically, those styled as Prop. Treas. Reg. § 1.1001-6). The proposed regulations contain changes to other provisions of the regulations, too, and the project ranges across a number of different areas of tax law.

The proposed regulations allow an issuer to transition away from LIBOR to a "qualified rate" without triggering a reissuance of the issuer's bonds or a deemed termination of its swaps.

The main rule is fairly simple. There's no modification that needs to be tested for a reissuance under Treas. Reg. § 1.1001-3 (or, for a swap, a deemed termination and re-execution of the swap) if:

  1. The issuer replaces LIBOR . . .
  2. . . . with one of the replacement rates (such as SOFR) listed in the proposed regulations. . .
  3. . . . and the replacement rate does not change the fair market value of the debt/swap or the currency of the prior rate.6

A rate that meets requirements 2 and 3 is called a "qualified rate" under the proposed regulations. It doesn't matter whether the debt is currently bearing interest at the LIBOR-based rate or whether the LIBOR-based rate exists merely as an option or as a fallback rate. This rule protects the issuer when it removes LIBOR or adds a qualified rate as a fallback.

The rule also protects an "associated alteration or modification." This phrase is defined as any change that is "associated with" the replacement of LIBOR that is "reasonably necessary to adopt or to implement" the replacement of LIBOR. As an example, the proposed regulations say that that an associated alteration or modification "may be a technical, administrative, or operational alteration or modification, such as a change to the definition of interest period or a change to the timing and frequency of determining rates and making payments of interest (for example, delaying payment dates on a debt instrument by two days to allow sufficient time to compute and pay interest at a qualified rate computed in arrears)." (Emphasis added.) As another example, the proposed regulations provide that an associated alteration or modification "may also be the addition of an obligation for one party to make a one-time payment in connection with the replacement of the IBOR-referencing rate with a qualified rate to offset the change in value of the debt instrument or non-debt contract that results from that replacement (a one-time payment)." (Emphasis added.) Given the bolded language in each example, we can assume that other things might be associated alterations or modifications, too.

Other changes are not protected by the proposed regulations, even if they're made at the same time as the replacement of LIBOR. If the bonds are qualified tender bonds, those other changes could be protected by the helpful rules in Notice 2008-41 and similar guidance (and one day soon, final Treas. Reg. § 1.150-3); otherwise, they'll need to be tested under the reissuance regulations in Treas. Reg. § 1.1001-3.

Oh great; another fair market value requirement.

I think we all felt the familiar pit in our stomachs when we saw the words "fair market value" in the proposed regulations. It is a concept that we spend a lot of time fighting about, either trying to convince other people to certify it to us, or to convince our clients to refuse to certify it to others. The regulations provide two helpful safe harbors for establishing that the unmodified debt/swap has a substantially equivalent fair market value to the modified debt/swap.

The fair market value safe harbor that is most likely to be beneficial to an issuer of tax-advantaged bonds allows the issuer to meet the fair market value requirement if the parties to the debt/swap are unrelated parties dealing at arm's length and they determine that the modified and unmodified instruments have a substantially equivalent fair market value,7 taking into account any one-time payment made in connection with the replacement. This makes sense – a good measure of the fair market value of property is the price that well-advised parties dealing at arm's length are willing to pay and charge for it. The proposed regulations are not clear on what would be required to document the fact that the issuer and holder have "determined" that the fair market value before the change is substantially equivalent to the fair market value after it. A certificate from a financial advisor might be the gold standard, but it might be difficult to get a financial advisor to tell you that, and you probably don't need it. The proposed regulations do not require a third-party certification, and it ought to be enough that the parties are dealing at arm's length and are making the change with the intent that the fair market value of the deal should stay the same in spite of the change.

The other safe harbor allows the issuer to meet the fair market value requirement if the historic average of LIBOR does not differ by more than 25 basis points from the historic average of the replacement rate, taking into account any spread or other adjustments to each rate, and taking into account any one-time payment made in connection with the replacement. To determine the historical average, an issuer can use an industry-wide standard (such as one recommended by ISDA for swaps or the Alternative Reference Rates Committee (“ARRC”) for debt), or it can use any reasonable method that takes into account every instance of the rate published during any continuous period beginning no earlier than 10 years before the change and ending no earlier than three months before the change. The issuer must use the same method and historical data for the old and new rates, and the historic average must be "determined in good faith by the parties with the goal of making the fair market value . . . substantially equivalent" before and after the modification.

The proposed regulations also provide that a modification to replace a LIBOR rate with a qualified rate on a swap or other derivative that is a "qualified hedge" and that is integrated with a tax-advantaged bond issue doesn't cause a deemed termination of the hedge,8 as long as the hedge as modified still meets the requirements in Treas. Reg. § 1.148-4(h), "as determined by applying the special rules for certain modifications of qualified hedges under [Treas. Reg.] § 1.148-4(h)(3)(iv)(C)." In other words, the modification to replace LIBOR in a swap with a qualified rate is still a "modification" of the swap within the meaning of Treas. Reg. § 1.148-4(h)(3)(iv)(A), but it doesn't cause a deemed termination of the swap under Treas. Reg. § 1.148-4(h)(3)(iv)(B). The references to Treas. Reg. §§ 1.148-4(h)(3)(iv)(B) and (C) mean that the issuer can ignore the fact that the existing qualified hedge is off-market as of the date of the modification, but the issuer must "re-identify" the swap on its books and records within 15 days after the modification according to the requirements of Treas. Reg. § 1.148-4(h)(2)(viii). There is, however, no need for the issuer to get a certification from the swap provider.

Issuers can apply the proposed regulations before Treasury finalizes them. Specifically, the proposed regulations say that "a taxpayer may choose to apply [Prop. Treas. Reg. §] 1.1001-6 of the final regulations to alterations and modifications that occur before that date, provided that the taxpayer and its related parties consistently apply the rules before that date."


1 The proposed regulations use the phrase "non-debt contract." The proposed regulations also go to great lengths to use the word "alteration" when they refer to a change to a debt instrument and to use the word "modification" when they refer to a change to a non-debt contract. While that semantic distinction is important for purposes of the existing regulations because there are no "reissuance regulations" for non-debt contracts, we'll be colloquial about it, as usual.

2 The proposed regulations apply not only to the replacement of LIBOR, but also to the replacement of any interbank offered rate ("IBOR," which is not to be confused with " Ybor") or a rate that references an IBOR. LIBOR is by far the most common (and maybe the only) IBOR that affects municipal bonds, so we'll use LIBOR as the shorthand for all of them.

3 [Sic.]

4 The proposed regulations apply both to the replacement of LIBOR with a qualified rate and the addition of a qualified rate as a fallback rate to LIBOR or the replacement of an existing LIBOR-based fallback rate with a qualified rate. We're going to use "replacement" as a shorthand for any or all of those things.

5 Whenever we talk about reissuance, we should always note that sometimes the change-in-law "risk" is in fact a change-in-law reward. When Congress enacts benefits that apply to bonds issued within a specific window of time, a reissuance may be desirable. For example, the interest paid on all tax-exempt private activity bonds that were issued in 2009 and 2010 to refund bonds issued in 2004 through 2008 was not subject to the alternative minimum tax. Thus, if an issuer triggered a reissuance in 2009 or 2010 of any tax-exempt private activity bond issued in 2004 through 2008, the interest on that bond would, presto-change-o!, become exempt from the alternative minimum tax. (This scenario highlighted the worst impulses of public finance tax lawyers (none of those at SPB, of course), when many bond lawyers (none of those at SPB, of course) grew exasperated that their tax lawyers, who had spent years telling them that even the slightest change would result in a reissuance when they didn't want a reissuance, were now telling them that they'd really have to move heaven and earth to trigger a reissuance when they did want one.)

6 All of this also applies equally to adding a qualified rate as a fallback to a LIBOR rate or as an additional layer of fallback to a LIBOR-based fallback rate. We will assume that this "same currency" requirement will be met in every case, so we're not going to talk about it any further. (If you're interested in replacing LIBOR with the Hong Kong Dollar Overnight Index (HONIA), call your bond counsel.)

7 Specifically, the FMV requirement is met "if the parties to the debt or non-debt contract "are not related (within the meaning of section 267(b) or section 707(b)(1) of the Internal Revenue Code) and the parties determine, based on bona fide, arm's length negotiations between the parties, that the fair market value of the debt instrument or non-debt contract" before the change is the same as it is after the change.

8 See Treas. Reg. § 1.148-4(h)(3)(iv)(B), which provides: "A deemed termination of a qualified hedge occurs if the hedge ceases to meet the requirements for a qualified hedge; the issuer makes a modification . . . that is material either in kind or in extent and, therefore, results in a deemed exchange of the hedge and a realization event to the issuer under [Internal Revenue Code] section 1001; or the issuer redeems all or a portion of the hedged bonds."

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