On Oct. 9, the IRS and the U.S. Department of the Treasury issued taxpayer-favorable proposed regulations that provide guidance on the transition from interbank offered rates (IBORs), including LIBOR (London Interbank Offered Rate), to other interest rates. This change was necessitated by action taken by U.K. regulators that will phase out LIBOR.
LIBOR is widely used as a reference rate for lending, derivatives, and other financial transactions. With the pending elimination of LIBOR, many debt instruments and derivatives will need to be modified to use a new interest rate. Generally, a change to an interest rate not contemplated by the original debt instrument results in taxable debt for debt exchange under Section 1.1001-3 of the regulations. Similarly, the timing rules for hedging transactions under Section 1.446-4 of the regulations could be affected if the change of reference rates in the debt instrument is a taxable exchange.
Section 1.1001-6 of the proposed regulations generally provides that there will not be a taxable debt for debt exchanges modified to replace LIBOR if all of the following conditions are met:
- The new interest rate is a qualified rate.
- The currency requirement is satisfied.
- The fair market value (FMV) test is satisfied.
Under the proposed regulations, a qualified rate is one of the following rates:
- The Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (SOFR)
- The Sterling Overnight Index Average (SONIA)
- The Tokyo Overnight Average Rate (TONAR or TONA)
- The Swiss Average Rate Overnight (SARON)
- The Canadian Overnight Repo Rate Average (CORRA)
- The Hong Kong Dollar Overnight Index (HONIA)
- The interbank overnight cash rate administered by the Reserve Bank of Australia (RBA Cash Rate)
- The euro short-term rate administered by the European Central Bank (€STR)
- Other rates identified as a successor to LIBOR by a central bank, bank, reserve bank, monetary authority, or similar institution (including any committee or working group of the institution) as a replacement for LIBOR or its local currency equivalent in that jurisdiction
The currency requirement is satisfied if the interest-rate benchmark after the modification is based on the same currency as the original debt instrument, or on a different currency if transactions in the new currency are otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency.
The FMV test is satisfied if the FMV of the modified debt instrument is substantially equivalent to the FMV of the debt instrument prior to modification. Two safe harbors are provided:
- The first presumes substantially equivalent fair market value if 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 that is made in connection with the alteration or modification.
- The second – the arm’s-length safe harbor – creates a presumption of substantially equivalent value if the new index is the result of bona fide arm’s-length negotiations between the parties. The arm’s-length safe harbor is not available if the issuer and holder of the loan are related parties under IRC Section 267(b) or Section 707(b)(1).
Section 1.446-4 of the regulations governs the timing of income from hedging transactions. Under these regulations, a change to the referenced interest rate on a debt instrument or a related hedge generally is treated as a termination of the hedge. The proposed regulations provide that a change from LIBOR to a qualified rate on either the debt instrument or the related hedge will not result in a termination of the hedge.
The proposed regulations will be effective for debt instruments issued on or after the date the final regulations are published. Taxpayers and their related parties can apply the proposed regulations to an alteration of the terms of a debt instrument or a modification of the terms of a nondebt contract that occurs before the date of publication of a Treasury decision adopting the rules as final.