The U.S. Department of the Treasury and the Internal Revenue Service on December 30, 2021, issued final regulations (“Final Regulations”) allowing a tax-free treatment of “covered modifications,” as defined, of certain contracts that transition from London Interbank Offered Rate (“LIBOR”) or another interbank offered rate (“IBOR”) to a different reference rate as a result of or in anticipation of the discontinuation of such IBOR (find link here). For purposes of the Final Regulations, a contract includes but is not limited to a debt instrument, a derivative contract, stock, an insurance contract and a lease agreement.
A “covered modification” is a contract modification that:
- replaces an operative rate that references a “discontinued IBOR,” defined as any IBOR being discontinued, but only during the period from the date it is announced that such IBOR will no longer be published until one year after the date such IBOR is no longer published, with a “qualified rate,” as defined,
- adds a qualified rate as a fallback to an operative rate that references a discontinued IBOR, and/or
- replaces a fallback rate that references a discontinued IBOR with a qualified rate.
A “qualified rate” is a rate described in the Final Regulations that is in the same currency as the discontinued IBOR or is otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency. Some of the rates listed in the Final Regulations include Secured Overnight Financing Rate, Sterling Overnight Index Average, Tokyo Overnight Average Rate, Swiss Average Rate Overnight, the euro short-term rate administered by the European Central Bank, a rate endorsed by a central bank, reserve bank or monetary authority as a replacement for a discontinued IBOR in that jurisdiction and a rate endorsed by the Federal Reserve. The list also includes a rate that is determined by reference to any of these listed rates, including a rate determined by adding or subtracting a specified number of basis points to or from such listed rate or by multiplying such listed rate by a specified number. The IRS may also list additional rates. A rate comprised of multiple fallback rates may be a qualified rate if each fallback rate separately satisfies the qualified rate requirements.
The Final Regulations extend the tax-free treatment of covered modifications that replace an operative rate to a “qualified one-time payment,” defined as a single cash payment that is intended to compensate a party for all or part of the basis difference between the discontinued IBOR identified in covered modification and the interest rate benchmark to which the qualified rate refers. Any other compensatory payments do not qualify for the tax-free treatment.
In addition, the Final Regulations treat as tax-free any “associated modification” to a covered modification, defined as a modification of the technical, administrative, or operational terms of a contract that is reasonably necessary to adopt a covered modification (roughly tracking the “benchmark replacement conforming changes” definition used in LIBOR replacement legislation in New York and the proposed legislation currently being considered by the Senate), as well as any incidental cash payments to compensate a party for small valuation differences resulting from a modification of the administrative terms of a contract.
On the flip side, the Final Regulations provide that a “noncovered modification,” defined as a modification that is not a covered modification, is subject to the general contract modification rules and may be treated as a taxable exchange. The Final Regulations describe and provide examples of noncovered modifications, including modifications that change the amount or timing of cash flows and that:
- intend to induce a party to perform an act necessary to consent to a covered modification,
- intend to compensate a party for a modification to the contract that is not a covered modification,
- are a concession granted to a party because such party is in financial difficulty
- are secured by a party to account for the credit deterioration of another party,
- intend to compensate a party for a change in rights or obligations that are not derived from the contract being modified (with exceptions for certain one-time payments), and
- are so identified in future IRS guidance.
The Final Regulations clarify that in the case where a covered modification is made at the same time as a noncovered modification, the covered modification is viewed as if it had been part of the contract prior to the noncovered modification, and the noncovered modification is tested separately to determine whether there is a taxable event.
The Final Regulations make various conforming changes to other regulations, including in relation to Real Estate Mortgage Investment Conduits (“REMICs”), investment trusts, integration and hedging rules, Foreign Account Tax Compliance Act (“FATCA”) and contingent payment debt instruments. In the case of investment trusts, the Final Regulations provide that a covered modification would not cause an investment trust to be treated as having a power to vary its investment and fail to classify as a grantor trust for tax purposes.
The Final Regulations contain provisions similar to the previously issued proposed LIBOR regulations (find link here) but did eliminate a proposed requirement that the fair market value of a modified contract be substantially equivalent before and after the modification.
The Final Regulations are effective on March 7, 2022, but taxpayers may rely on them for earlier contract modifications made before that date if certain conditions are met.