On December 30, 2021, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released final regulations addressing the principal tax implications of modifications to debt instruments, derivatives and certain other contracts related to the planned elimination of certain interbank offered rates (IBORs). The final regulations were published in the Federal Register on January 4, 2022.
The final regulations under Treas. Reg. §1.1001-6 provide that certain modifications made to a contract to replace an IBOR with a new reference rate generally will not constitute a taxable exchange of the contract. The final regulations generally apply to modifications occurring on or after March 7, 2022.
A significant amount of debt and nondebt transactions provide for payments based on an IBOR, such as U.S. dollar (USD) LIBOR, which is commonly incorporated in U.S. bank loans. On March 5, 2021, the administrator of LIBOR — the ICE Benchmark Administration (IBA) — announced that the publication of overnight, one-month, three-month, six-month and 12-month USD LIBOR will cease immediately following publication on June 30, 2023, and that the publication of all other currency and tenor variants of LIBOR will cease immediately following the LIBOR publication on December 31, 2021. However, the IBA has indicated that it will continue to publish synthetic GBP LIBOR and synthetic JPY LIBOR for a limited period after December 31, 2021 and may also publish synthetic USD LIBOR for a limited period after June 30, 2023.
To address the planned elimination of IBORs, Treasury and the IRS issued proposed regulations under Treas. Reg. §1.1001-6 on October 9, 2019. Under the proposed regulations, a modification of a debt or nondebt contract to replace an IBOR based rate with a qualified rate generally would not constitute a taxable exchange of the instrument under Internal Revenue Code (IRC) Section 1001 (or a “legging out” (termination) of a tax integrated transaction or a termination of either leg of a tax hedging transaction). Among other requirements, to constitute a qualified rate, the proposed regulations required that the fair market value of the contract immediately after the modification be substantially equivalent to the fair market value of the contract prior to the modification. Two fair market value safe harbors were provided. Any modifications other than certain “associated alterations” (such as a simultaneous change to the maturity date) would be analyzed separately under Treas. Reg. §§1.1001-1(a) and 1.1001-3.
On October 9, 2020, Treasury and the IRS released Rev. Proc. 2020-44. The Rev. Proc. provides that a modification of a debt or nondebt contract to incorporate “fallback” language published by the Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA) will not constitute a taxable exchange of the instrument under Section 1001 (or a legging out of a tax integrated transaction or a termination of either leg of a tax hedging transaction). As discussed below, the final regulations issued on December 30, 2021 provide that modifications described in section 4.02 of Rev. Proc. 2020-44 are covered modifications and, therefore, do not result in a taxable exchange under Treas. Reg. §1.1001-1(a).
The final regulations finalize the proposed regulations, with certain notable changes discussed below.
The final regulations provide that a covered modification of a contract does not result in a taxable exchange under Treas. Reg. §1.1001-1(a). For this purpose, the term contract is defined to include (but is not limited to) debt instruments, derivative contracts, insurance contracts and leases.
A covered modification is a modification to replace an operative rate referencing a discontinued IBOR with a qualified rate, a modification to include a qualified rate as a fallback rate (i.e., a rate that will replace an operative rate should the operative rate cease to be published), or a modification to replace a fallback rate that references a discontinued IBOR with a qualified rate, in each case together with any associated modifications. A covered modification also includes modifications to the terms of a contract described in section 4.02 of Rev. Proc. 2020-44.
Associated modifications are limited to modifications to the technical, administrative or operational terms of the contract necessary to adopt or implement the modification, as well as any incidental cash payments, which are cash payments to compensate a counterparty for small valuation differences resulting from the modification of the administrative terms of the contract (such as the valuation differences resulting from the difference in observation periods under a contract).
As noted, the final regulations require that the modification incorporate a qualified rate. The final regulations broadly define qualified rate to include a qualified floating rate under Treas. Reg. §1.1275-5(b) (without regard to the limitation on multiples in Treas. Reg. §1.1275-5(b)) and lists as examples the Secured Overnight Financing Rate (SOFR), the Sterling Overnight Index Average (SONIA), and the euro short-term rate administered by the European Central Bank. To constitute a qualified rate, the rate must also be based on transactions conducted in the same currency (or otherwise are reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency) as the discontinued IBOR that it is replacing.
Contracts providing for IBORs, such as debt instruments, often incorporate a basis point spread (for example, the rate may be three-month LIBOR plus 100 basis points). In connection with a modification from an IBOR to a qualified rate, a basis adjustment spread may be required (for example, the spread for SOFR may be 142 basis points). In lieu of an adjustment spread, the parties may agree to a one-time payment in an amount equal to the present value of the adjustment — referred to in the final regulations as a “qualified one-time payment.” The term qualified rate includes a basis adjustment spread as well as a qualified one-time payment. However, any amount paid in excess of the amount required to compensate the other party for the basis difference between the discontinued IBOR and the interest rate benchmark to which the qualified rate refers is treated as a noncovered modification (discussed below).
The final regulations do not provide guidance on the character or source of qualified one-time payments. Under the proposed regulations, the character and source of a one-time payment made by a given payor was the same as the source and character of a payment under the contract by that payor. Treasury and the IRS received several comments with respect to such payments, which they are continuing to study. Until further guidance is published, taxpayers are permitted to rely on the guidance in §1.1001-6(d) of the proposed regulations.
In some cases, a contract will be modified to provide for multiple fallback rates (often referred to as a fallback waterfall). A fallback waterfall may provide for an initial fallback rate to the currently operative rate, as well as one or more fallback rates to such initial or subsequent fallback rates. Under the final regulations, a rate comprised of more than one fallback rate (such as a fallback waterfall) will be a qualified rate only if each individual fallback rate separately satisfies the requirements to be a qualified rate, with one exception: If the likelihood that any value will ever be determined by refence to a fallback rate is remote (i.e., it is remote that a particular fallback rate will ever be activated), that fallback rate is treated as a qualified rate.
As noted above, the final regulations do not retain the fair market value requirement provided by the proposed regulations. In its place, the final regulations provide a list of modifications that are excluded from the definition of covered modifications. Each of the modifications included in this list involves a modification to the amount or timing of contractual cash flows combined with a specific, prohibited purpose. Specifically, the final regulations exclude modifications (or portions of a modification) to the amount or timing of contractual cash flows where:
- The change is intended to induce one or more parties to perform any act necessary to consent to a covered modification (i.e., a consent fee);
- The change is intended to compensate one or more parties for a noncovered modification (i.e., a payment by the issuer to the lender to compensate the lender for agreeing to amend a financial covenant);
- The change is a concession granted to a party on account of its financial difficulty, or a concession secured by one party to account for the credit deterioration of the other party (i.e., a reduction in the interest rate on account of financial difficulty);
- The change is intended to compensate one or more parties for a change in rights or obligations under a different contract (i.e., an increase in interest rate to compensate the lender for changes to a separate contract between the parties); or
- The change is a modification identified in published IRS guidance as having a principal purpose of achieving a result that is unreasonable in light of the purpose of the final regulations.
It should be noted that that the final regulations treat a consent fee paid to the counterparty in connection with a covered modification as a noncovered modification (to be tested under IRC Section 1001). Banks and other counterparties commonly require payment of consent fees in connection with modifications, and since the intent of the regulations is to facilitate the transition from IBOR (through modifications of existing contracts), it is interesting that consent fees are excluded from the definition of covered modification.
If a covered modification is made at the same time as a contemporaneous noncovered modification, Treas. Reg. §§1.1001-1(a) and 1.1001-3 (as appropriate) apply to determine whether the noncovered modification results in a taxable exchange. For this purpose, the covered modification is treated as occurring prior to the noncovered modification (and treated as part of the terms of the contract prior to the noncovered modification). For example, if the interest rate on a loan is modified in a manner that is a covered modification and, contemporaneously, the maturity date is extended (a noncovered modification), only the maturity date extension is tested under Section 1001. This approach also applies to noncovered modifications listed above.
Under the proposed regulations, there was a concern that a modification that failed to satisfy the fair market value requirement may be analyzed (in its entirety) under Section 1001, increasing the likelihood that the modification would constitute a taxable exchange. The removal of the fair market value requirement and the bifurcation of covered and noncovered modifications under the final regulations is thus a welcome change from the proposed regulations.
Tax Hedging Transactions and Tax Integrated Transactions
The final regulations provide special rules intended to prevent certain negative tax consequences with respect to tax hedging transactions and tax integrated transactions. Specifically, a covered modification of one leg of a tax hedging transaction is not treated as a disposition or termination (within the meaning of Treas. Reg. §1.1446-4(e)(6)) of either leg of the hedging transaction. Further, a covered modification of one or more contracts that are part of an integrated transaction under Treas. Reg. §1.988-5 or §1.1275-6 is not treated as a leg-out of the integrated transaction, provided that no later than the end of the 90-day grace period beginning on the date of the first covered modification of any such contract, the financial instrument that results from any such covered modification satisfies the requirements to be a §1.1275–6 or §1.988-5 hedge with respect to the qualifying debt instrument that results from any such covered modification. The 90-day grace period was incorporated to provide taxpayers with sufficient time to make corresponding changes to each of the tax integrated positions to ensure that the tax integration requirements continue to be satisfied.
The final regulations also permit taxpayers to enter into (and integrate) temporary hedges during the 90-day grace period to manage the economic risk posed by temporary mismatches between the components of a tax integrated transaction without triggering a legging out of the tax integrated transaction.
The final regulations provide special rules pertaining to fast-pay stock (under Treas. Reg. §301.7701(l)-3), investment trusts (under Treas. Reg. §301.7701-4) and REMIC regular and residual interests (under Treas. Reg. §1.860G-1).
Transfer Pricing Considerations
One important area that is not covered by the final regulations is the impact of the transition from IBOR on transfer pricing for intercompany financial instruments. Absent any further guidance, companies are left to interpret how existing transfer pricing rules under Treas. Reg. §1.482 can be applied to ensure arm’s length pricing is maintained.
The final regulations apply to modifications that occur on or after March 7, 2022. A taxpayer may choose to apply the final regulations to modifications occurring prior to March 7, 2022, provided that the taxpayer and all related parties (within the meaning of IRC Section 267(b) or Section 707(b)(1)) apply the final regulations to all modifications of the terms of contracts that occur before that date.
The final regulations provide much needed guidance to taxpayers required to modify existing contracts to address the elimination of IBORs. However, because the final regulations require that any noncovered modification be tested to determine if a taxable exchange results, taxpayers should carefully review each modification (and any associated cash payments) to confirm that the entire modification is properly treated as a covered modification. In many instances, certain changes to the contractual rights and obligations may be outside the transition from IBOR to a qualified rate, and therefore would need to be analyzed.
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Written by Michael Bauer, Kevin Ainsworth and Richard Liebman. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com.