Replacing a key benchmark interest rate, the London Inter-Bank Offered Rate (LIBOR) is a stated goal of financial regulators. LIBOR rates are quoted for many different currencies, including U.S. dollars, and are referenced in lending and derivative transactions throughout the world. Trillions of dollars of transactions are based, in whole or in part, on U.S. dollar LIBOR.
When new reference rates are adopted in place of LIBOR, many debt and derivative agreements will need to be modified. The prospect of these modifications to reference interest rates raises the issue of whether the modifications should give rise to recognition of gain or loss for tax purposes. Treasury and the IRS have issued proposed regulations addressing this issue (the proposed regulations).
Modifications of debt and non-debt instruments in general
For U.S. tax purposes, if the terms of a financial instrument are sufficiently modified, the modification is treated as an exchange of the old, unmodified instrument for a new instrument. This principle applies to all financial instruments. In addition, a more specific set of rules exists to determine whether a debt instrument modification is treated as a debt-for-debt exchange for tax purposes. Debt-for-debt exchange treatment applies if the debt modification is a “significant modification” as defined under regulations. The results of debt-for-debt exchange treatment can include taxable gain or loss for the debt holder and cancellation of debt income or repurchase premium for the debt issuer.
Proposed regulations addressing switches from LIBOR to other reference rates
The proposed regulations smooth the way for parties to financial instruments to modify their agreements to use certain alternatives to LIBOR (termed 'qualified rates') without triggering exchange treatment for tax purposes. This guidance applies to modifications that do not change the fair market value (FMV) of the debt or derivative, taking into account adjustments for any one-time payments in connection with the modification. As valuation may be a difficult determination, the proposed regulations provide two safe harbors under which the FMV of a modified instrument would be deemed the same as the FMV of the unmodified instrument.
If there are additional modifications made contemporaneously with a LIBOR transition modification, the modification transaction would be bifurcated for determining its tax consequences. The LIBOR transition modification would be deemed to occur first. These principles would apply regardless of whether the modification directly substitutes a qualified rate for LIBOR, or provides a qualified rate as a future fallback for when LIBOR becomes unavailable.
- In addition, the proposed regulations also provide collateral guidance regarding:
- The impact of LIBOR transition modifications on integrated transactions and hedges
- The source and character of any one-time payment made in connection with a LIBOR transition modification
- The treatment of debt and other financial instruments as grandfathered under sections 163(f), 871(m), and/or 1471
- Original issue discount (OID) accruals when a fallback rate provided for in a debt instrument takes effect
- Application of tax hedging rules in connection with a LIBOR transition modification
- Rules designed to enable Real Estate Mortgage Investment Conduits (REMICs) to maintain REMIC status upon a LIBOR transition modification
- Interest expense allocations under section 882 of foreign corporations with income effectively connected with a U.S. business
The proposed regulations generally would be effective for transactions that occur on or after their date of finalization. However, taxpayers generally may choose to rely on the proposed regulations ahead of their finalization. Taxpayers who are parties to LIBOR-based instruments should consider these proposed regulations as they modify those instruments to accommodate alternative benchmark rates.