The LIBOR transition became a little easier in October.
Most debt in project finance transactions and many swaps, hedges and other contracts are tied to LIBOR. For example, a loan might require payment of floating interest at a spread 137.5 basis points above LIBOR.
The UK Financial Conduct Authority has not committed to publishing LIBOR past 2021.
The Federal Reserve Bank of New York began publishing a secured overnight financing rate, or “SOFR,” in April 2018 as a replacement for LIBOR for US-dollar denominated instruments. Other countries have chosen other reference rates for their currencies. For example, the UK will use a sterling overnight index average called SONIA, and Japan will use a Tokyo overnight average rate called TONAR. Separate reference rates have been selected for the Eurozone, Canada, Switzerland, Australia and Hong Kong.
Debt instruments and non-debt contracts that refer to LIBOR will have to be amended or replaced.
Under US tax rules, any debt instrument that undergoes a “significant modification” is considered to have been exchanged for a new debt instrument. This can trigger taxes. There is limited guidance about the tax consequences of amending non-debt contracts.
The IRS made the LIBOR transition easier in October.
It said in proposed regulations that it will not view a debt instrument or other contract as having changed if it is amended, or replaced with a new instrument, to substitute a new reference rate or provide a fallback to LIBOR.
However, three things must be true.
First, the amended instrument must be substantially equivalent in value. Second, there cannot be a change in currency. Third, the new reference rate chosen must be a “qualified rate,” meaning a rate, like SOFR, selected or recommended by a central bank or similar authority.
As part of the LIBOR replacement, one party may have to make a one-time payment to the other party to keep the two instruments equivalent in value. The general principle that the instrument is considered unchanged extends to any such “associated alterations” related to the LIBOR replacement
Requiring that two instruments remain substantially equivalent in value to avoid triggering a tax creates risk.
The IRS provided two “safe harbors.”
One is where the parties to the instrument are unrelated and determine through negotiation that the amended instrument or contract remains substantially equivalent in value.
The other requires mapping how the new rate compares historically to LIBOR. As long as the two rates have remained within 25 basis points of each other on average, then the values will be considered substantially equivalent. The lookback period for calculating averages cannot be more than 10 years or end more than three months before the rate is replaced.
Some debt instruments are exempted from changes in tax law that took effect after they were issued. They will not be considered to have been reissued for purposes of such grandfather provisions on account of replacing LIBOR.
Most lenders and borrowers have not updated their existing debt instruments yet. Anyone issuing a new loan or hedge must consider whether to punt for now or write the replacement rate into the instrument. Another option is a hybrid approach of hardwiring the changeover, but leaving the rate and spread to be filled in later.