Replacing LIBOR with SOFR will not trigger US tax consequences, as long as the change does not cross one of four tripwires, the IRS said in January.
“Associated modifications” can also be made at the same time without triggering US taxes.
The UK Financial Conduct Authority stopped publishing one-week and two-month LIBOR rates after 2021, but it is continuing to publish “synthetic” sterling and yen LIBOR rates using a methodology that does not require collecting information from panel banks. It is also publishing the remaining LIBOR tenors — including the most commonly used one-, three- and six-month rates — through June 2023.
It may require publication of one-, three- and six-month dollar LIBOR past June 2023 using a similar synthetic methodology. However, any such synthetic rates are expected to be published only for a limited time.
US regulators have been discouraging US banks from entering into new LIBOR contracts and encouraging them to add ARRC hardwired fallback language to LIBOR-based instruments so that the instruments will automatically adjust to a new benchmark rate once LIBOR stops being published.
The US expectation is that most of the market will shift to SOFR, a replacement rate for dollar-denominated instruments.
ARRC stands for the Alternative Reference Rates Committee. It is a group of private-market and government participants convened by the Federal Reserve Board and Federal Reserve Bank of New York to advise on LIBOR transition issues.
The ARRC fallback language describes when and how references to a current benchmark rate will be replaced with a new benchmark rate. It includes mechanisms for determining the replacement benchmark rate and a spread adjustment that will be added to the replacement benchmark to account for any differences between the new and old benchmark rates.
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 said in proposed regulations in 2019 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 had to be true about the amended instrument. (For more detail, see “The LIBOR Transition” in the August 2019 NewsWire.)
The IRS issued a separate revenue procedure in October 2020 that said anyone adding the ARRC hardwired fallback language to a debt instrument or hedge will not trigger taxes. (For more detail, see “IRS Tries to Simplify LIBOR Transition” in the December 2020 NewsWire.)
The IRS issued final regulations in January 2022 in an attempt to make the rules in this area simpler, but they are in the form of abstract guidance that will leave unanswered questions.
They add a new section 1.1001-6 to existing IRS regulations for calculating gain or loss when property is exchanged for cash or another property.
A “covered modification” does not trigger taxes.
A change in the base rate from LIBOR to SOFR is such a modification, as long as it does not cross one of four tripwires.
“Associated modifications” can be made at the same time. These are modifications that are reasonably necessary to adopt the rate change.
An example of an associated modification is an “incidental” cash payment intended to compensate the counterparty for small valuation differences resulting from a change in administrative terms of the contract, like a change in the interest period or in the timing and frequency of determining rates and making interest payments.
Another example is a single cash payment intended to compensate the other party for the basis point difference between the old and new benchmark rates.
The IRS said that if other changes are made — for example, extending the maturity of the loan — then whether the other changes are a “significant modification” should be analyzed separately as if the switch from LIBOR and other associated modifications are already part of the base instrument.
The form of the covered modification does not matter. For example, the parties can enter into a new loan or other contract or merely amend an existing contract.
The same rules apply broadly to all types of contracts, including debt instruments, derivatives, stock, insurance policies and leases.
LIBOR does not have to be replaced with a single rate. The replacement can include one or more fallback rates.
However, all bets are off if the parties cross one of four tripwires.
A change in the amount or timing of cash flows under the debt instrument or other contract crosses a line if it is intended to do one of four things.
One is induce a party to “perform any act necessary to consent” to the change in the benchmark rate.
Another is to compensate the party for other changes besides the change in the benchmark rate.
Another is to make concessions to a party that is experiencing financial difficulties or to a party to account for credit deterioration of another party.
The last tripwire is if the change in amount or timing of cash flows is intended to compensate a party for a change in rights or obligations not derived from the contract being modified. (For related other coverage, see “SOFR Too Volatile?” in the August 2020 NewsWire and “LIBOR End May Disrupt Emerging Market Lending” in the October 2020 NewsWire.)