The IRS Wishes LIBOR a Fond Farewell with Final Regulations
LIBOR (London Interbank Offered Rate) has been universally used as a reference interest rate for contracts and debt instruments. But LIBOR, along with certain other interbank offered rates (IBORs), is going away. The organization that administers LIBOR has announced that the principal rates expressed in US dollars will be discontinued after June 30, 2023, and other rates expressed in other currencies have been discontinued as of December 31, 2021.
With LIBOR no longer available, contracts and debt instruments that rely on LIBOR and other IBORs as reference rates will need to be modified to incorporate new reference rates. As explained below, this modification could result in a taxable exchange transaction under Internal Revenue Code (IRC) Section 1001. To address this issue, on January 4, 2022, the IRS published final regulations (Final Regulations) under Section 1001, which are added to the Treasury Regulations as Section 1.1001-6. This Tax Blog post briefly describes the Section 1001 issue, and summarizes the Final Regulations.
Section 1001 Issue
Section 1001 provides rules for determining the amount and recognition of gain or loss from the sale or other disposition of property. Gain or loss is generally recognized upon the exchange of property for other property differing materially in kind or extent. A significant modification of a debt instrument can result in a deemed exchange of such instrument for a modified instrument that differs materially either in kind or in extent for purposes of Section 1001.
A modification of a debt instrument is generally any alteration of a legal right or obligation of the issuer or holder of the debt instrument, unless such alteration occurs by operation of the instrument’s terms. In the case of both debt instruments and non-debt contracts, absent the guidance provided in the Final Regulations, the change of a base reference rate (e.g., LIBOR or another IBOR), or the addition or modification of a fallback provision to address the possible elimination of an IBOR, may be a material modification resulting in a recognition event under Section 1001.
The Final Regulations
The Final Regulations provide guidance for modifying contracts and debt instruments to account for the elimination of a reference rate, while avoiding a recognition event under Section 1001. The term “contract” is defined broadly, to include debt instruments, derivative contracts, insurance contracts, stock, leases and other contractual relationships. The Final Regulations provide a single set of rules for all debt and non-debt contracts to determine whether a modification of such contract to address the discontinuance of an IBOR will result in a taxable event.
Paragraphs (b) through (g) of Section 1.1001-6 provide the operative rules for a “covered modification” which will not give rise to a taxable exchange. Section 1.1001-6(h)(1) defines a “covered modification” as a modification, or portion of a modification, whereby the terms of a contract are modified:
- To replace an operative rate that references a “discontinued IBOR” with a “qualified rate,” to add an obligation for one party to make a “qualified one-time payment” (if any), and to make “associated modifications” (if any);
- To include a qualified rate as a fallback to an operative rate that references a discontinued IBOR and to make associated modifications (if any); or
- To replace a fallback rate that references a discontinued IBOR with a qualified rate and to make associated modifications (if any).
Under Section 1.1001-6(h)(3), a rate generally is a “qualified rate” if variations in the value of the rate can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency. The Final Regulations list examples of qualified rates, including the Secured Overnight Financing Rate (SOFR), the Sterling Overnight Index Average, the Tokyo Overnight Average Rate, the Swiss Overnight Average Rate, and the euro short-term rate administered by the European Central Bank, as well as rates determined by adding or subtracting basis points to or from the rate or by multiplying the rate by a specified number. Other qualified rates include:
- 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 the Alternative Reference Rates Committee as a replacement for USD LIBOR, provided that the Federal Reserve Bank of New York is an ex officio member of the Alternative Reference Rates Committee at the time of the selection, endorsement, or recommendation; and
- A rate that is determined by reference to a rate described above.
Section 1.1001-6(j) describes certain modifications expressly excluded from the definition of a “covered modification,” and also provides a number of examples showing various types of covered and noncovered modifications. Section 1.1001-6(j) describes such excluded modifications as modifications which change the amount or timing of contractual cash flows, where such change is intended:
- To induce one or more parties to perform any act necessary to consent to one of the covered modifications described above;
- To compensate one or more parties for a modification to the contract apart from any of the covered modifications described above;
- To grant a concession to a party to the contract because that party is experiencing financial hardship, or to reflect a concession secured by a party to the contract to account for the credit deterioration of another party to the contract; or
- To compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified.
The Final Regulations include an anti-avoidance rule excluding from the scope of “covered modifications” those modifications changing the amount or timing of contractual cash flows identified in published guidance as having a principal purpose of achieving a result deemed unreasonable in light of the purpose of the Final Regulations.
The Final Regulations contain additional detailed guidance regarding their application to:
- Integrated transactions and hedging transactions;
- The Foreign Account Tax Compliance Act (FATCA);
- Fast-pay stock (e., stock where dividends are economically a return of the holder’s investment, as opposed to a return on the holder’s investment); and
- The rules for investment trusts.
The Final Regulations apply to modifications of contracts that occur after March 7, 2022. A taxpayer may choose to apply the Final Regulations retroactively to modifications occurring prior to March 7, 2022, provided that the taxpayer and all related parties apply the Final Regulations retroactively.
 The published final regulations can be found here: Federal Register: Guidance on the Transition From Interbank Offered Rates to Other Reference Rates
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