Final LIBOR transition regulations aim to minimize tax consequences

Executive summary

Final regulations issued on Jan. 4, 2022¹ address the transition from LIBOR (London Interbank Offered Rate) to other variable rate indices. The regulations’ purpose is to minimize the U.S. federal income tax consequences of the transition. Taxpayers amending, replacing or terminating any debt or derivative contracts because of the transition from LIBOR should consider the tax consequences in light of these regulations. 

LIBOR cessation 

LIBOR remains the predominant U.S. dollar-denominated interest rate index at present. Published LIBOR rates are used to determine rates for (1) variable rate debt instruments such as commercial bank loans, and (2) variable rate returns on derivatives (e.g., many swap contracts). LIBOR rate publication is scheduled to cease immediately after June 30, 2023.²

Transition from LIBOR

Debt and derivative contracts will need to reference a variable rate index other than LIBOR once LIBOR publication ceases. Some contracts already have “fallback” provisions that specify replacement of LIBOR with another index. For example, many of these contracts specify SOFR (Secured Overnight Financing Rate) as a replacement index. Contracts that do not have fallback provisions may need to be amended, replaced or terminated to accommodate the transition from LIBOR. 

What is at stake

A modification of a financial instrument (such as a debt instrument or a derivative contract) may be treated for federal income tax purposes as an exchange of the old, unmodified instrument for a new one. If treated as an exchange, recognition of income, deduction, gain or loss may apply. 

For debt instruments in particular, exchange treatment applies if the modification is a “significant modification” within the meaning of the tax regulations.³ Where exchange treatment applies to a debt modification, what is at stake for a taxpayer depends on the situation. For example, the tax consequences of exchange treatment may be significant in either of these two situations:    

1. The taxpayer is a debt issuer at risk for potential cancellation of debt COD income because it has outstanding traded debt that is with a fair market value substantially below its stated principal amount, or 
2. The taxpayer is a debt holder at risk for potential gain recognition because it holds debt that it acquired at a discount. 

Final regulations broaden safe harbors

The final regulations adopt many of the principles of proposed regulations⁴ issued in 2019. The final regulations do not eliminate the safe harbors the IRS published in Rev. Proc. 2020-44.⁵ Instead, they effectively broaden the safe harbor coverage of contractual modifications that replace LIBOR (or any other interbank offered rate) with a new qualified rate. Consistent with the regulations’ purpose to minimize the U.S. federal income tax consequences of the LIBOR transition, a transaction within their safe harbor coverage (a “covered modification” in the regulations’ parlance) would not receive exchange treatment for federal income tax purposes.⁶

The 2019 proposed regulations generally would have required that the fair market value (FMV) of the modified contract be substantially equivalent before and after the modification. That approach would have carried the potential to impose FMV determination and proof requirements in various circumstances, and these requirements would have given rise to some administrative difficulty for both taxpayers and the IRS. 

The final regulations take a different approach, which is welcome. In addition to broadening the safe harbors available, they replace the FMV substantial equivalency requirement with a list of excluded modifications. Excluded modifications are particular types of transactions that cannot qualify for the regulations’ safe harbors and may accordingly result in taxable exchange treatment. 

In addition, while the proposed regulations provided separate rules for debt and non-debt contracts, the final regulations take a simpler approach and provide a single set of rules for all contracts. 

The final regulations apply to transactions occurring after March 6, 2022. A taxpayer may apply the final regulations to transactions occurring prior to March 7, 2022, provided that the taxpayer and its related parties do so consistently. 

Conclusion

Taxpayers that are parties to debt instruments, derivatives or other contracts that reference LIBOR can now analyze LIBOR transition modifications to these contracts with greater certainty. The final regulations issued on Jan. 4, 2022 are intended to minimize the tax consequences of modifying a contract to replace LIBOR with another qualified rate. Taxpayers generally should consult their tax advisors and consider whether the modifications of their debt or derivative contracts meet the safe harbors set out in the final regulations, or whether the modifications instead are excluded modifications that may be treated as taxable exchanges. 

¹T.D. 9961, 87 F.R. 166 (Jan. 4, 2022).

²Information on LIBOR Cessation is available on the website of the Intercontinental Exchange, Inc. (the ICE), which administers LIBOR

³See generally Reg. section 1.1001-3. For additional discussion of certain debt modification issues arising during the COVID-19 pandemic, see our April 2020 article: Debt modifications during the COVID-19 crisis.

⁴Notice of Proposed Rulemaking, REG-118784-18, 84 F.R. 54068 (Oct. 9, 219). We covered these proposed regulations in a prior article. 

⁵Rev. Proc. 2020-44, 2020-45 I.R.B. 991 (Oct. 9, 2020). With respect to LIBOR-based variable rate debt, Rev. Proc. 2020-44 provides that the modification of a debt instrument to incorporate an “ARRC Fallback” does not result in exchange treatment. An “ARRC Fallback” is certain contract language recommended by the AARC (Alternative Reference Rates Committee) in ARRC documents referenced by Rev. Proc. 2020-44. 

⁶See Reg. section 1.1001-6(b).