Menu
Tax Notes logo

Treasury Offers Safe Harbors From Taxes Due to IBOR Transition

Posted on Oct. 9, 2019

Treasury has issued proposed regulations enabling taxpayers to avoid adverse tax consequences when they modify financial instruments to reflect the global transition from interbank offered rates (IBORs) to new reference rates.

Under the proposed regs (REG-118784-18), released October 8, replacing IBOR reference rates with qualified rates in debt instruments or derivatives won’t be treated as a section 1001 realization event if the fair market value of the modified instrument or contract is substantially equivalent to its FMV before the change was made.

Practitioners largely welcomed the relief given in the guidance, although they said some of the proposed rules may need fine-tuning.

“It’s clear that Treasury and the IRS wanted to provide as much flexibility as they could while still making sure that the guidance is no broader than necessary to simply replace your IBOR with a new reference rate,” Brennan Young of Mayer Brown told Tax Notes.

The government explained in the preamble that it expects the regs will minimize potential market disruption and reduce tax uncertainty as global markets shift away from IBORs, which are benchmark interest rates based on the rate at which banks lend to and borrow from one another on the interbank market. IBORs are used by banks to determine interest rates and payment obligations for a wide range of financial products, such as derivatives, bonds, loans, structured products, and mortgages.

After U.K. regulators announced in 2017 that LIBOR — the most widely used benchmark — will no longer be available after the end of 2021, countries around the world began making plans to transition away from IBORs and find alternative risk-free rate benchmarks.

The United States is expected to select the secured overnight financing rate (SOFR) as the new interest rate benchmark for U.S. dollar-denominated derivatives and other financial contracts.

The Alternative Reference Rates Committee (AARC) — a group of private market participants convened by the Federal Reserve Board and the New York Federal Reserve Bank to plan the transition from the U.S. dollar LIBOR — had submitted letters to Treasury and the IRS in April and June urging them to issue guidance addressing the tax consequences of moving to new benchmark rates.

Replacing Reference Rates

The proposed regs address a key stakeholder concern by providing that modifying the terms of a debt instrument or non-debt contract to replace an IBOR reference rate with a qualified rate won’t be treated as a “material modification” for section 1001 purposes, and therefore won’t result in a taxable exchange.

The same rule would apply to any associated changes that are reasonably necessary to implement the replacement rate.

However, to obtain that favorable outcome, the modified debt instrument or non-debt contract must use the same currency, and its FMV must be substantially equivalent to its FMV before the change was made.

Because of the difficulty in valuing debt instruments, Treasury is providing two safe harbors to ease compliance.

Under one safe harbor applicable for non-related parties, the FMV equivalence requirement will be satisfied if, through bona fide, arm’s-length negotiations of the replacement rate, the parties determine that the FMV of the modified debt instrument or non-debt contract is substantially equivalent to its FMV before the change was made.

Under the other safe harbor applicable for related parties, the FMV equivalence requirement will be satisfied if, at the time of the modification, the historic average of the IBOR-referencing rate is within 25 basis points of the historic average of the rate that replaces it.

“Taxpayers will likely be surprised that the largely comprehensive and favorable proposed rules may be conditioned on a valuation determination that is not explicitly satisfied by following adjustment determinations selected or recommended by” the International Swaps and Derivatives Association, ARRC, or a similar body, said Justin Weiss of KPMG

Weiss said it would be helpful to expand on or clarify the safe harbors in the proposed regulations. “Perhaps Treasury will be quick to use its reserved authority to provide additional safe harbors when adjustment determinations are finalized.”

According to Jason Schwartz of Cadwalader, Wickersham & Taft LLP, some parties might run into snags if the associated changes made to replace the IBOR reference rate aren’t “reasonably necessary” to implement the replacement. He noted that the proposed regs give an example of the parties increasing the interest rate to reflect a decline in the borrower’s creditworthiness.

“In that case, the regs require that you essentially bifurcate the transaction into two modifications,” Schwartz said. “One modification is to change the LIBOR rate to another rate with a substantially equivalent FMV. The second modification is to change the interest rate.”

Schwartz said there are areas in which the parties doing a bifurcation will need to be careful.

“There might be questions at the margins as to how much the interest rate has changed, what belongs to the ‘good’ modification, and how much was attributable to the decline in creditworthiness,” Schwartz said. “Whatever the parties ultimately decide could have significant bearing on their tax consequences — gain recognition, change in holding period, etc.”

One-Time Payments

The proposed regs also provide that the source and character of one-time payments made by borrowers to account for differences between the IBOR and replacement rate will have the same source and character that would otherwise apply to a payment made by the borrower regarding the debt instrument or non-debt contract that is altered or modified.

Schwartz said it isn't clear how that rule will work in some contexts.

“The regs explicitly reserve on how you treat payments by the lender to the borrower,” Schwartz said. “In the context of debt instruments, it would be more helpful if the regs explicitly provided that the payments are interest by the borrower rather than, say, a fee, which could attract withholding tax.”

For derivatives, he said some payments might be treated as a return of capital or as giving rise to a capital gain or loss. "Some payments may be treated as [fixed or determinable annual or periodic] income, which could give rise to withholding tax,” Schwartz said. 

Schwartz said he hopes the final regs clarify that one-time payments don’t attract U.S. withholding tax.

Copy RID