As market participants evaluate their loan portfolios and implement strategies to transition away from the London Interbank Offered Rate ("LIBOR"), they must address not only third-party loans, but related-party loans as well.
LIBOR is a global interest rate benchmark index based on the average of interbank offered rate quotes for deposits of various currencies and durations in the London market derived from quotations of panel banks. Floating interest rates embedded in many types of financial contracts, including loans, derivatives, and bonds, historically were, and in some cases still are, often calculated by reference to LIBOR, with a margin spread of a given number of basis points. Due to various concerns, including potential market manipulation, a decision was reached to cease publishing LIBOR as a reference rate in financial transactions. One week and two month USD LIBOR rates, which were rarely used, were discontinued on December 31, 2021, and all remaining USD LIBOR rates are scheduled to be discontinued after final quotation on June 30, 2023. Many existing contracts that use LIBOR as a reference rate do not provide an effective fallback if LIBOR becomes unavailable. While much has been written about the need to modify third-party financial contracts to eliminate references to LIBOR, the same concerns arise with respect to related-party financial arrangements that reference LIBOR, such as related-party loan agreements. Related-party loan agreements that include LIBOR as a reference rate should be modified as well, in part because Treasury regulations under Internal Revenue Code Section 482 require such loan agreements to reflect an arm's length rate of interest. Treas. Reg. 1.482-2(a). Arguably, after June 30, 2023 (and possibly sooner), reference to LIBOR in related-party loan agreements would no longer reflect arm's length behavior.
On July 29, 2021, the Alternative Rates Reference Committee ("ARRC"), a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from USD LIBOR to a more robust reference rate, recommended the use of 1-, 3-, and 6-month forward looking term rates based on the Secured Overnight Financing Rate ("SOFR") published by the CME Group for use in the syndicated loans market. On May 8, 2022, that recommendation extended to 12-month SOFR. The ARRC's endorsement of the SOFR term rate for business loans and related derivatives and securitizations is a critical positive development for the financial markets. If SOFR becomes unavailable, a waterfall of fallback rates is potentially available as well, including a Fed recommended replacement for SOFR, the Fed's Overnight Bank Funding Rate, and the Fed's Open Market Committee Target Rate. Generally speaking, financial contracts executed after December 31, 2021 should use a reference rate other than LIBOR or incorporate LIBOR fallback language that refers to a strong and clearly defined alternative reference rate. Whether modifying an existing financial instrument or entering into a new one, consultation with an economist, an accountant or a banker may be necessary. Because SOFR, unlike LIBOR, is effectively a risk-free rate, a spread adjustment or other addition to an applicable margin likely will be required to derive an economically equivalent rate.
Tax Consequences of LIBOR Phase Out
Generally speaking, amending existing financial contracts, for example to replace a LIBOR rate with a new rate, can have tax consequences. On October 8, 2019, the IRS released proposed regulations under section 1001 of the Internal Revenue Code to address the LIBOR transition (the "Proposed Regulations"). On December 30, 2021, the IRS published final regulations under section 1001 for the LIBOR transition (the "Final Regulations"). Most importantly, as discussed in more detail below, the final version no longer contains the requirement in the Proposed Regulations that the fair market value of the instrument after the replacement or addition is substantially equivalent to the fair market value of the instrument before the replacement or addition, replacing that standard with a list of modifications that fall outside the relief provided by the Final Regulations.
For debt instruments and other financial instruments, a main US federal income tax concern surrounding the replacement of a LIBOR rate on an outstanding financial instrument is whether, under Treas. Reg. 1.1001-3, the replacement (or addition to include a fallback mechanic) results in the deemed exchange of the instrument for a deemed new instrument that differs materially in kind or in extent. This deemed exchange could result in current gain or loss recognized to a party to the instrument. In the debt context, a deemed exchange only occurs if the replacement or addition is a "significant modification." There are multiple, specifically enumerated tests for determining whether a modification is "significant."
Before the Final Regulations, taxpayers had only the existing 1.1001-3 regulations (that are not specific to LIBOR transition), Proposed Regulations and Rev. Proc. 2020-44 to rely on. Under the Proposed Regulations, replacement of LIBOR generally did not result in a deemed exchange for US federal income tax purposes if: (i) the fallback rate was a qualifying rate (which was broadly defined); and (ii) the fair market value of the instrument after the replacement or addition was substantially equivalent to the fair market value of the instrument before the replacement or addition. The Final Regulations do away with the fair market value requirement in favor of the creation of a new category of modifications that are not covered by the Final Regulations and must be tested under prior law, including Treas. Reg. 1.1001-3. Under Rev. Proc. 2020-44, if an existing instrument were amended to include certain enumerated fallback mechanics, then the amendment was blessed as not resulting in a deemed exchange. The Revenue Procedure was set to expire on December 31, 2022, but the Final Regulations make the relief provided in the revenue procedure permanent.
The Final Regulations follow a simple structure that blesses all modifications to any instruments that fit the definition of "covered modifications" other than modifications that fit the definition of "noncovered modifications." A modification to the terms of a contract, including any debt instrument, is a covered modification if the terms of the contract are modified to: (1) replace an operative rate that references LIBOR with a qualified rate (discussed below); (2) include a qualified rate as a fallback to an operative rate that references LIBOR; or (3) replace a fallback rate that references LIBOR with a qualified rate. A modification of the terms of a contract includes any modification of the terms of the contract regardless of the form of the modification, such as an amendment to an existing contract or exchange of one contract for another. The Final Regulations clarify that if an existing contract is modified to adopt LIBOR fallbacks, the testing for whether there has been a taxable exchange excepted by the regulations must be done both when the fallback mechanics are adopted and when the fallback rate is implemented, if ever. If the actual fallback is not a covered modification under the Final Regulations, taxpayers are left with standards under prior law such as the debt modification tests under Treas. Reg. 1.1001-3 to determine whether a modification is a "significant modification." The Final Regulations are clear that the relief provided by regulations applies only to replacing or providing fallback mechanics for LIBOR or a similar interbank rate.
The Final Regulations provide a broad scope for what constitutes a qualified rate, including any rate that can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds in the currency in which a debt instrument is denominated, within the meaning of Treas. Reg. 1.1275-5(b). This definition includes SOFR, among other rates. The Final Regulations address how modification of an instrument to include a fallback waterfall should be tested in terms of whether the rate is a qualified rate. The Final Regulations provide that each rate in the waterfall must generally be a qualified rate. A rate is only a qualified rate if it is based in the same currency as the rate in the existing contract. Associated modifications include the modification of any technical, administrative, or operational terms of a contract that is reasonably necessary to adopt or to implement a LIBOR replacement modification.
A LIBOR replacement modification to a contract is a noncovered modification where the terms of the contract are modified to change the amount or timing of contractual cash flows and that change is: (1) intended to induce one or more parties to perform any act necessary to consent to the modification to the contract; (2) intended to compensate one or more parties for a modification to the contract not related to LIBOR replacement; (3) either a concession granted to a party to the contract because that party is experiencing financial difficulty or a concession secured by a party to the contract to account for the credit deterioration of another party to the contract; or (4) intended to compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified. To the extent a modification made in connection with LIBOR transition is a covered modification, the modification is not treated as a deemed exchange of the contract for a deemed new contract that differs materially in kind or extent within the meaning of Treas. Reg. 1.1001-1(a). If a noncovered modification occurs contemporaneously with a covered modification, Treas. Reg. 1.1001-1(a) or 1.1001-3, as appropriate, applies to determine whether the noncovered modification results in a deemed exchange. In making this determination for the noncovered modification, the covered modification is ignored as though it were a pre-existing term of the contract being analyzed.
Adjustable Interest Rate (LIBOR) Act
The search for a legislative solution to the problem of legacy contracts that (i) linked to LIBOR that are impossible, or virtually impossible, to amend, and (ii) lack fallback provisions that implement a replacement rate that is not linked to LIBOR or that do not result in a fixed interest rate, began with the passage by the New York legislature of Senate Bill S297B on March 24, 2021. On December 8, 2021 the U.S. House of Representatives passed H.R. 4616, the Adjustable Interest Rate (LIBOR) Act ("LIBOR Act") in order to provide a federal solution for LIBOR-linked contracts that need to transition away from LIBOR but that lack the mechanics to do so. On February 28, 2022 a group of senators announced that they planned to introduce their own LIBOR-transition legislation. This legislation made a number of revisions that tightened the language of the House bill and offered three substantive changes: new protections for banks that use non-SOFR benchmarks; broader coverage that includes any interbank offered rate, not LIBOR only; and tax provisions that confirmed that amendments to a financial contract that implement transition to a replacement benchmark for LIBOR, and nothing more, will not be treated as a taxable sale, exchange or other disposition of property for purposes of section 1001 of the Internal Revenue Code. However, apparently due to jurisdictional considerations, the tax provision in the Senate legislation ultimately was dropped from the final legislation introduced in the U.S. Senate on March 8, 2022.
On March 15, 2022, President Biden signed into law the LIBOR Act as Division U of H.R. 2471, Consolidated Appropriations Act, 2022.1 The LIBOR Act is a federal solution for legacy LIBOR-linked contracts that contain inadequate fallback provisions, or none at all. The LIBOR Act preempts similar state legislation. The purpose of the LIBOR Act is to establish a clear and uniform process on a nationwide basis for replacing LIBOR in existing contracts that do not provide for the use of a clearly defined replacement benchmark. For contracts that contain no fallback provision or contain fallback provisions which neither identify a specific USD LIBOR benchmark replacement nor identify a person with authority to select a USD LIBOR benchmark replacement, a benchmark replacement recommended by the Board of Governors of the Federal Reserve will automatically replace the USD LIBOR benchmark in the contract after June 30, 2023. The recommended benchmark replacement will be based on SOFR published by the Federal Reserve Bank of New York, including any recommended spread adjustment and benchmark replacement conforming changes. (As noted above, a spread adjustment is necessary because, unlike LIBOR, SOFR is effectively a risk-free rate.) The final version of the legislation also provides additional legal certainty with respect to the use of non-SOFR benchmarks not included in the earlier version of the legislation passed by the U.S. House of Representatives.
While businesses could take the position that the LIBOR Act will save their related-party loan agreements or other financial contracts by operation of law, the more prudent course would seem to be for related parties to proactively modify their related-party financial agreements to eliminate references to LIBOR. Because related-party agreements often follow a simpler and more abbreviated documentation approach that may not include hardwired fallbacks, and because there are few, if any, issues of the parties being difficult to locate or of difficult adverse positions, proactive modification should be relatively straightforward and in line with the behavior most likely to be followed by parties acting at arm's length to fit within the tax safeharbors. Related-party loans are not particularly different structurally than third-party loans, but it is important to remember that if they are linked to LIBOR, they need to be transitioned prior to June 30, 2023.
1. The LIBOR Act was included in the Consolidated Appropriate Act, 2022, a copy of which is available at https://www.congress.gov/117/bills/hr2471/BILLS-117hr2471enr.pdf. See pgs. 777-786.
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