- The federal government in the last two years has provided guidance for an orderly transition from the London Interbank Offered Rate (Libor) to other reference rates without resulting in significant modifications.
- The current U.S. dollar Libor publication is scheduled to end by June 30, 2023, giving parties time to modify existing debt instruments, derivative contracts and other contracts to replace references to existing Libor rates with alternative reference and fallback rates.
- Without the safe harbor protection of the LIBOR Regulations, such adjustments ordinarily could result in "significant modifications" for federal income tax purposes, potentially resulting in realization of income, deduction, gain or loss, or other federal income tax consequences to the parties associated with such instruments and contracts.
The U.S. dollar London Interbank Offered Rate (Libor) publication is scheduled to end by June 30, 2023. With roughly nine months to go as of this writing, parties still have time to make modifications to existing debt instruments, derivative contracts (hedges) and other contracts to replace references to existing Libor rates with alternative reference rates and fallback rates. Ordinarily, modifications of this sort could result in "significant modifications" for federal income tax purposes, which could result in the realization of income, deduction, gain or loss, or other federal income tax consequences to the parties of such instruments and contracts. Generally, a significant modification of a debt instrument would result in recognition of gains or losses for federal tax purposes. For tax-exempt bonds and interest rate hedges that were integrated with the tax-exempt bonds (i.e., a qualified hedge), a significant modification would result in a reissuance of the bonds and a deemed termination of such a hedge.
In the last two years, the federal government has provided guidance to provide for an orderly transition away from Libor to other reference rates without resulting in significant modifications. Revenue Procedure 2020-44 , which was released by the U.S. Department of the Treasury and the Internal Revenue Service on Oct. 9, 2020, provides a safe harbor for adding Alternative Reference Rates Committee (ARRC) or International Swaps and Derivatives Association fallback language to existing agreements referencing Libor (see previous Holland & Knight alert, "IRS Promotes Use of Fallback Language to Assist with Libor, IBOR Transition," July 28, 2021).
Final Treasury Regulation Section 1.1001-6 (LIBOR Regulations), which was published in the Federal Register on Jan. 4, 2022, provides more comprehensive guidelines to modifications of agreements without being deemed to be significant modifications. In short, the LIBOR Regulations provide that a "covered modification" of an agreement will not result in a significant modification, and for tax-exempt bonds and interest rate hedges, a covered modification of either would not result in a reissuance or deemed termination of either, respectively, for federal income tax purposes. A "covered modification" includes any modification to:
- replace an operative rate that references a "discontinued IBOR" with a "qualified rate"
- add an obligation for one party to make a "qualified one-time payment"
- include a "qualified fallback rate" to an operative rate that references a discontinued IBOR
- make "associated modifications" in connection with any of the above-mentioned modifications
- incorporate permissible fallback language as described in Revenue Procedure 2020-44
A "qualified rate" and a "qualified fallback rate" include any of the following:
- a qualified floating rate, as defined in Treasury Regulation Section 1.1275-5(b) but without regard to the limitations on the 0.65 to 1.35 multiples (examples of qualified floating rates generally include Secured Overnight Financing Rate (SOFR), the Sterling Overnight Index Average, the Tokyo Overnight Average Rate, the Swiss Average Rate Overnight and the euro short-term rate administered by the European Central Bank)
- an alternative, substitute or successor rate selected, endorsed or recommended by the central bank, reserve bank, monetary authority or similar institution (including any committee or working group thereof) as a replacement for a discontinued IBOR or its local currency equivalent in that jurisdiction
- a rate selected, endorsed or recommended by ARRC as a replacement for USD Libor, provided that the Federal Reserve Bank of New York is an ex officio member of ARRC at the time of the selection, endorsement or recommendation
- a rate that is determined by reference to any of the three above-mentioned rates, including a rate determined by adding or subtracting a specified number of basis points to or from the rate or by multiplying the rate by a specified number
- a rate identified as a qualified rate in guidance published in the Internal Revenue Bulletin(e.g., Revenue Procedure 2020-44)
A "discontinued IBOR" is any interbank offered rate during the period beginning on the date of the announcement that the administrator of the interbank offered rate has ceased or will cease to provide the interbank offered rate permanently or indefinitely and no successor administrator is expected as of the time of the announcement to continue to provide the interbank offered rate and ending on the date that is one year after the date on which the administrator of the interbank offered rate ceases to provide the interbank offered rate. For the one-week and two-month U.S. dollar Libor tenors that were discontinued as of Dec. 31, 2021, such tenors will no longer be treated as discontinued IBORs as of Dec. 31, 2022. For the overnight, one-month, three-month, six-month and 12-month U.S. dollar Libor tenors for which their publication is expected to discontinue as of June 23, 2023, such tenors would no longer be treated as discontinued IBORs as of June 23, 2024. Therefore, after such dates, such applicable tenors of Libor will no longer be treated as discontinued IBOR, the non-significant modification relief under the IBOR Regulations will have expired.
A "qualified one-time payment" is a single cash payment that is intended to compensate the other party or parties for all or part of the basis difference between the discontinued IBOR and the interest rate benchmark to which the qualified rate refers.
An "associated modification" is a modification of the technical, administrative or operational terms of a contract that is reasonably necessary to adopt or to implement the modifications needed to introduce a qualified rate or a qualified fallback rate into an existing contract. An associated modification could include 1) an incidental cash payment intended to compensate a counterparty for small valuation differences resulting from a modification of the administrative terms of a contract, such as the valuation differences resulting from a change in observation period, and 2) a change to the definition of interest period or a change to the timing and frequency of determining rates and making payments of interest.
Items to Note in LIBOR Regulations Application
Multiple Fallback Rates: If the modifications include adding multiple fallback rates (i.e., a waterfall), the LIBOR Regulations provide that the rate being tested is a qualified rate only if each individual fallback rate separately satisfies the requirements to be a qualified rate. Unless the likelihood of a fallback rate is remote, if such fallback rate cannot be determined at the time of the modification to satisfy the requirements for a qualified rate, then such a fallback rate is not treated as a qualified rate and, therefore, the waterfall of rates will not be considered to be a qualified fallback rate. The LIBOR Regulations give an example in which a lender provides in the first tier of a waterfall for a qualifying rate and a second tier that allows the lender to select a fallback rate based on industry standards at the time. The example provides that the entire waterfall is a qualifying rate if, at the time of the modification, the likelihood that the amount of interest on the debt instrument will ever be determined by reference to the fallback rate in the second tier of the fallback is remote.
Noncovered Modifications: A "noncovered modification" is any modification that is not a "covered modification" and would need to be tested under the existing reissuance rules under Treasury Regulations Sections 1.1001-1(a) and 1.1001-3. If modifications include both covered modifications and noncovered modifications, the covered modification is treated as part of the terms of the contract prior to the noncovered modification. Some examples of noncovered modifications include changes to the amount or timing of contractual cash flows:
- to induce one or more parties to perform any act necessary to consent to a covered modification
- to compensate one or more parties for a noncovered modification
- to either grant a concession granted to a party to the contract because that party is experiencing financial difficulty or secure a concession to account for the credit deterioration of another party to the contract
- to compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified in a covered modification, or
- that are otherwise identified in the Internal Revenue Bulletin as having a principal purpose of achieving a result that is unreasonable considering the purpose of the LIBOR Regulations
Qualified Hedges: A covered modification of a qualified hedge (e.g., an interest rate swap) that was integrated with an issue of tax-exempt bonds is not treated as terminated, provided that, no later than 90 days after the date of the first covered modification of either the qualified hedge or the hedged bonds, the now-modified qualified hedge satisfies the special rules under Treasury Regulation Section 1.148–4(h)(3)(iv)(C) for retesting the qualified hedge with respect to the hedged bonds that result from any such covered modification. Any qualified one-time payment with respect to the hedge or the hedged bonds (or both) is allocated in a manner consistent with the allocation of a termination payment for a variable yield issue and treated as a series of periodic payments. Note, however, that the covered modification safe harbor of the LIBOR Regulations does not apply to "super-integrated" hedges.
Adjustable Interest Rate (LIBOR) Act: While some states have adopted separate legislations for fallback interest rates when the underlying contracts are silent, on March 15, 2022, the U.S. Congress enacted the Adjustable Interest Rate (LIBOR) Act (LIBOR Act) as part of the Consolidated Appropriations Act, 2022, to provide a national uniform set of procedures (thus superseding any similar state and local legislations, which did not address any federal income tax matters such as reissuance matters addressed in the LIBOR Regulations) to automatically replace Libor in certain contracts on the first London banking day after June 30, 2023, with a benchmark replacement recommended by the Board of Governors of the Federal Reserve. The LIBOR Act covers contracts that reference certain tenors of U.S. dollar Libor (the overnight, one-month, three-month, six-month and 12-month tenors) and that contain 1) no fallback provision, or 2) fallback provisions that neither identify a specific U.S. dollar Libor benchmark replacement nor identify a person with authority to select a U.S. dollar Libor benchmark. The recommended benchmark replacement will be based on SOFR and will include tenor spread adjustments as set forth in the LIBOR Act (see previous Holland & Knight alert, "Summary of Federal USD Libor Discontinuance Law," March 15, 2022). While the enacted version of the LIBOR Act does not contain the Senate's proposed tax language providing that automatic replacement of Libor will not result in significant modifications (i.e., reissuances for federal income tax purposes), the replacement rate recommended by the Board of Governors of the Federal Reserve nonetheless should satisfy the second definition of a qualified rate described above.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.