The LIBOR transition remains a work in progress.

The US tax authorities issued more guidance in October in an effort to dispel fears that adjusting loan agreements and hedges so that they still work after the UK stops publishing LIBOR will have adverse tax consequences.

The UK Financial Conduct Authority plans to stop publishing one-week and two-month LIBOR rates after 2021, but will continue to publish remaining LIBOR tenors –- including the most commonly used one-month and three-month rates--through June 2023.

US regulators are discouraging US banks in the meantime from entering into new LIBOR contracts after 2021 to add hardwired fallback language to both existing and new LIBOR-based instruments. 

The US expectation is that the market will shift to use of SOFR, a replacement rate for dollar-denominated instruments, or use LIBOR but include so-called ARRC hardwired fallback language that will automatically adjust to another rate once LIBOR stops being published.

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.

 Andrew Coronios, a finance partner with Norton Rose Fulbright in New York, said banks do not seem enthusiastic at this point about hardwiring instruments to SOFR.  The problems are “borrower concerns about not knowing a rate before an interest period begins, lack of clarity about the spread adjustment required to convert LIBOR instruments into SOFR instruments, quarter-end volatility in SOFR, and operational issues faced by banks in transitioning their systems to SOFR,” Coronios said.  (For further discussion, see “SOFR too volatile?” in the August 2020 NewsWire.)

The market is also waiting for US regulators to start publishing “term SOFR” rates that would be more consistent with current LIBOR rate-setting practice.  Coronios said panelists on a November webinar hosted by the LSTA, the trade group for the North American syndicated loan market, said they are seeing more examples of lenders modifying the ARRC fallback language “to provide for a ‘second flip’ of the replacement benchmark to term SOFR if that becomes available after a loan has already transitioned from LIBOR to a SOFR replacement benchmark before term SOFR is available.”

Jeremy Hushon, a project finance partner in Washington, said he suspects a “zombie LIBOR” rate is likely to play a larger role over the next few years.  Lenders with large books of loans with tenors beyond 2023 delay amending their existing LIBOR instruments in the hope that term SOFR rates will emerge by June 2023.  (For the effects of the transition on emerging markets, see “LIBOR end may disrupt emerging market lending” in the October 2020 NewsWire.)

Two competing references rates--AMERIBOR and the Bank Yield Index--have not gained much traction in the syndicated loan market, Coronios said, but may have appeal to some smaller and mid-sized banks who do not believe SOFR reflects their costs of funds.

Meanwhile, the Internal Revenue Service tried in a revenue procedure in mid-October to ease fears about the tax consequences of changing the benchmark interest rate in a debt instrument or hedge.

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 a year ago 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 about the amended instrument.  (For more detail, see “The LIBOR transition” in the August 2019 NewsWire.)

The new revenue procedure is an attempt to make things even simpler by saying that anyone adding the ARRC hardwired fallback language to a debt instrument or hedge will not trigger taxes. 

Certain deviations are allowed from the hardwired fallback language without creating issues.  If the deviations go beyond these, then the instrument will be analyzed as if the fallback language were part of the original instrument to assess whether the additional changes are a substantial modification.

There is no problem with deviations that are needed to make the instrument enforceable in another country or that omit part of the fallback language that cannot, under any circumstances, affect operation of the modified contract.  An example is omitting any discussion about fallback rates tied to other interbank offered rates besides LIBOR if LIBOR is the current benchmark rate.

The new guidance is in Revenue Procedure 2020-44.