Replacing Discontinued Interest Rates Does Not Trigger Taxable Gain Or Loss

Taxes

Final regs generally don’t require taxpayers to recognize gain or loss when modifying contracts to replace discontinued interbank offered rates. However, to qualify for this favorable treatment, the contract modifications must meet specific conditions related to replacement interest rates and cash payments between borrowers and lenders.

Published on January 4, 2022, T.D. 9961 contains final regs that provide guidance on the tax consequences of a transition away from the use of IBORs in debt instruments, derivatives, and other contracts. The final regs are necessary to address the possibility that a modification of contract terms to replace an IBOR with a new reference rate could require the realization of income, deduction, gain, or loss, or could have other tax consequences.

T.D. 9961 contains amendments to regs under code sections:

  • 860A and 860G (taxation of real estate mortgage investment conduits);
  • 1001 (determining amount and recognition of gain or loss);
  • 1271 (treatment of amounts received on retirement, sale, or exchange of debt instruments);
  • 1275 (gains or losses on debt instruments with original issue discount); and
  • 7701(l) (recharacterization of conduit arrangements).

This article focuses on the addition of new reg. section 1.1001-6.

Discontinued IBORs

On July 27, 2017, the Financial Conduct Authority (the United Kingdom regulator tasked with overseeing the London interbank offered rate), announced that publication of all currency and term variants of LIBOR, including U.S. dollar LIBOR, may cease after 2021.

The Intercontinental Exchange (ICE) Benchmark Administration, the administrator of LIBOR, announced on March 5, 2021, that publication of overnight, one-month, three-month, six-month, and 12-month U.S. dollar LIBORs will cease immediately after the LIBOR publication on June 30, 2023. Moreover, publication of all other currency and tenor (or maturity period) variants of LIBOR will cease immediately after the LIBOR publication on December 31, 2021.

However on September 29, 2021, the Financial Conduct Authority announced that it will compel the ICE Benchmark Administration to continue to publish one-month, three-month, and six-month sterling LIBOR and Japanese yen LIBOR after December 31, 2021, using a synthetic method that is not based on panel bank contributions.

The Financial Conduct Authority has indicated that it may also require the ICE Benchmark Administration to publish one-month, three-month, and six-month U.S. dollar LIBORs after June 30, 2023, using a similar synthetic method. However, these synthetic pound-sterling, yen, and U.S. dollar LIBORs are expected to be published only for a limited period.

Several tax issues may arise when taxpayers modify contracts in anticipation of the discontinuation of LIBOR or another IBOR. For example, a contract modification may be treated as an exchange of property for other property differing materially in kind or extent under reg. section 1.1001-1(a), giving rise to gain or loss.

A contract modification may also have consequences under the rules for integrated and hedging transactions, withholding on foreign accounts under chapter 4 of the code (sections 14711474), fast-pay stock, investment trusts, OID, and real estate mortgage investment conduits (REMICs). The final regs address all these scenarios.

To minimize potential market disruption and facilitate orderly transition after the discontinuation of LIBOR and other IBORs, proposed regs (REG-118784-18) were published October 9, 2019. They generally provide that modifying a debt instrument, derivative, or other contract in anticipation of an elimination of an IBOR is not treated as an exchange of property for other property differing materially, in kind or extent, under reg. section 1.1001-1(a). The proposed regs also adjust other tax rules to minimize the collateral consequences of the transition away from discontinued IBORs.

Rev. Proc. 2020-44

The Alternative Reference Rates Committee (ARRC), whose ex officio members include the U.S. Treasury, was convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York in 2014. To support the transition away from U.S. dollar LIBOR, the ARRC published recommended fallback language for inclusion in the terms of cash products like syndicated loans and securitizations.

The ARRC has also engaged with the International Swaps and Derivatives Association (ISDA) to ensure that the contractual fallback provisions in derivative contracts are robust enough to prevent market disruptions when LIBOR is discontinued or becomes unreliable.

To that end, ISDA developed the 2020 IBOR fallbacks protocol by which the parties to derivative contracts can incorporate improved fallback provisions into the terms of those contracts. On October 9, 2020, Treasury and the IRS released Rev. Proc. 2020-44, 2020-45 IRB 991, in advance of finalizing the proposed regs to support the adoption of the ARRC’s recommended fallback provisions and the ISDA fallbacks protocol.

Rev. Proc. 2020-44 provides that a modification within the scope of the revenue procedure is not treated as an exchange of property for other property differing materially in kind or extent under reg. section 1.1001-1(a). Also, Rev. Proc. 2020-44 generally provides that a modification within the scope of the revenue procedure will not result in closing or legging out of an integrated transaction or terminating either leg of a hedging transaction.

The final regs are intended to help taxpayers adjust to the discontinuation of widely used interest rate benchmarks. To achieve this purpose, Treasury and the IRS have departed from ordinary tax rules in the final regs.

Reg. Section 1.1001-6eg. section 1.1001-6(a)(k) (paragraphs (g) and (i) are reserved) addresses taxpayer transitions from IBORs. Reg. section 1.1001-6(a) describes the rules as addressing the modification of contract terms as part of a transition away from LIBOR and other IBORs. The guidance includes:

  • operative rules for covered modifications;
  • rules for integrated and hedging transactions;
  • withholding guidance under chapter 4;
  • rules for fast-pay stock;
  • rules for investment trusts;
  • definitions related to covered modifications (including four examples);
  • a description of modifications that are not covered modifications (including seven examples); and
  • effective dates.

For rules addressing OID on debt instruments with an interest rate that references a discontinued IBOR, taxpayers are directed to reg. section 1.1275-2(m). For rules addressing interests in a REMIC that reference a discontinued IBOR, taxpayers are directed to reg. section 1.860G-1(e).

Section 1001 Treatment

The general rule in reg. section 1.1001-6(b)(1) provides that a covered modification of a contract is not treated as an exchange of property for other property differing materially in kind or extent under reg. section 1.1001-1(a).

Section 1001 governs the recognition of gain or loss from the sale or other disposition of property. Reg. section 1.1001-1(a) generally requires taxpayers to recognize gain or loss realized from the exchange of property for other property differing materially in kind or extent. Reg. section 1.1001-3 provides rules for determining whether modification of a debt instrument is an exchange under reg. section 1.1001-1(a). Under reg. section 1.1001-3(b), a significant modification of a debt instrument is treated as an exchange of the original debt instrument for an instrument that differs materially in kind or extent. A modification that is not significant is not an exchange under reg. section 1.1001-1(a).

Reg. section 1.1001-6(b)(1) states that covered modifications to a debt instrument are not exchanges under reg. sections 1.1001-1 and -3 and provides an example. If the terms of a debt instrument that pays interest at a rate referencing the U.S. dollar LIBOR are modified to provide that the debt instrument pays interest at a qualified rate referencing the Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (SOFR), and the modification is not excluded under paragraph (j), it is not treated as the exchange of property for other property differing materially in kind or extent under reg. section 1.1001-1(a).

Subparagraph (b)(2) addresses contemporaneous noncovered modifications. If a covered modification is made at the same time as a noncovered modification, reg. sections 1.1001-1(a) and -3 apply to determine whether the noncovered modification is treated as an exchange of property for other property differing materially in kind or extent.

In applying reg. section 1.1001-1(a) or -3, the covered modification is treated as part of the terms of the contract before the noncovered modification. For example, if the parties to a debt instrument modify the interest rate in a manner that is a covered modification and extend the final maturity date at the same time, which is a noncovered modification, only the extension of the final maturity date is analyzed under reg. section 1.1001-3. In performing the analysis, the (covered) modified interest rate is treated as a term of the instrument before the (noncovered) extension of the final maturity date.

Integrated and Hedging Transactions

Paragraph (c) describes the effect of a covered modification on integrated and hedging transactions and will be the subject of a future article. The rules determine the effect of a covered modification on:

These modifications are generally treated as not legging out of the integrated transaction.

Chapter 4 Withholding

Reg. section 1.1001-6(d) addresses coordination of the transition away from discontinued IBORs with existing withholding obligations under chapter 4 of the code. Chapter 4 addresses withholding on payments to foreign entities, and section 1471 requires withholding on payments to foreign financial institutions.

Reg. section 1.1471-2(b)(1) provides that a withholdable payment does not include a payment made under a grandfathered obligation. Reg. section 1.1471-2(b)(2)(i)(A)() defines a grandfathered obligation as any obligation outstanding on July 1, 2014.

Reg. section 1.1471-2(b)(2)(iii) provides that a debt obligation is treated as outstanding on any date after the issue date. However, any material modification of an outstanding obligation will cause the obligation to be treated as newly issued on the effective date of the modification. Reg. section 1.1471-2(b)(2)(iv) provides that a material modification is any significant modification of the instrument as defined in reg. section 1.1001-3(e).

Reg. section 1.1001-6(d) provides that a contract modification is not a material modification under reg. section 1.1471-2(b)(2)(iv) to the extent it is a covered modification. The rules in reg. section 1.1001-6(b)(2) apply under reg. section 1.1471-2(b)(2)(iv) when a modification to a contract includes both a covered modification and a contemporaneous noncovered modification.

Fast-Pay Stock

Reg. section 1.1001-6(e) addresses coordination of the transition away from discontinued IBORs with the fast-pay stock rules in reg. section 1.7701(l)-3, which prevents tax avoidance by persons participating in fast-pay arrangements by recharacterizing them to ensure the participants are taxed in a manner that reflects their economic substance. (Prior coverage: Tax Notes Int’l, Jan. 30, 2023, p. 556.)

Under reg. section 1.7701(l)-3(b)(2)(ii), the determination of whether stock is fast-pay is based on all the facts and circumstances. Stock is generally examined when it is issued to determine if it is fast-pay stock. However, stock that is not fast-pay stock when issued is examined upon a significant modification in the terms of the stock or a significant change in the relevant facts and circumstances.

Under reg. section 1.1001-6(e), a covered modification of stock is not treated as a significant modification in the terms of the stock or related agreements, nor a significant change in facts and circumstances under reg. section 1.7701(l)-3(b)(2)(ii).

If a covered modification is made at the same time or as part of a plan that includes a noncovered modification, and the noncovered modification is a significant modification in the terms of the stock or related agreements or a significant change in facts and circumstances, then reg. section 1.7701(l)-3(b)(2)(ii) applies to determine whether the stock is fast-pay taking into account all facts and circumstances, including both the covered and noncovered modification.

Investment Trusts

Reg. section 1.1001-6(f) addresses coordination of the transition away from discontinued IBORs with the rules for investment trusts. Under reg. section 301.7701-4(c)(1), an investment trust will not be classified as a trust if there is a power under the trust agreement to vary the investment of the certificate holders.

Under reg. section 1.1001-6(f), a covered modification of a contract held by an investment trust does not manifest a power to vary the investment of the certificate holders under reg. section 301.7701-4(c)(1). Moreover, a covered modification of an ownership interest in an investment trust does not manifest a power to vary the investment of the certificate holders under reg. section 301.7701-4(c)(1).

Definitions

Paragraph (h)(1)-(6) provides definitions of covered modification, noncovered modification, qualified rate, discontinued IBOR, associated modification, and qualified one-time payment.

Subparagraph (h)(1) defines a covered modification as a modification of contract terms that is:

  • described in subdivisions (h)(1)(i)-(iii); and
  • not described in subparagraphs (j)(1)-(5).

Any contract modification described in section 4.02 of Rev. Proc. 2020-44, in guidance that supplements the list in section 4.02, or in the definitions on which section 4.02 relies, is treated as a covered modification (see reg. section 601.601(d)(2)(ii)(a) (designating the Internal Revenue Bulletin as the authoritative instrument of the IRS for publication of official rulings and procedures)).

This includes any modification of the contract terms regardless of form. For example, a modification may be an exchange of one contract for another, an amendment to an existing contract, or a modification accomplished indirectly through transactions with third parties. This is the case regardless of whether the modification is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. A contract includes (but is not limited to) a debt instrument, derivative contract, insurance contract, lease agreement, and stock.

Under subdivision (h)(1)(i)-(iii), a covered modification occurs when contract terms are modified to:

  • replace an operative rate that references a discontinued IBOR with a qualified rate and add an obligation for one party to make a qualified one-time payment (and to make any associated modifications); or
  • include a qualified rate as a fallback to an operative rate that references a discontinued IBOR (and to make any associated modifications); or
  • replace a fallback rate that references a discontinued IBOR with a qualified rate (and to make any associated modifications).

Subparagraph (h)(2) defines noncovered modification as a modification that is not a covered modification.

Subdivision (h)(3)(i)-(iv) provides a definition of qualified rate and will be the subject of a future article. The definition includes a general rule, a list of specific qualified rates, guidelines for fallback rates, and four examples.

Subparagraph (h)(4) defines discontinued IBOR as any IBOR described in subdivision (h)(4)(i) or (ii), but only during the period beginning on the date of the announcement described in subdivision (h)(4)(i) or (ii) and ending on the date that is one year after the date on which the administrator of the IBOR ceases to provide it.

The announcement in subdivision (h)(4)(i) occurs when the administrator of the IBOR announces that it has ceased or will cease to provide the IBOR permanently or indefinitely, and no successor administrator is expected as of the time of the announcement to continue to provide the IBOR.

The announcement in subdivision (h)(4)(ii) is identical to the one in subdivision (h)(4)(i) except that, instead of being made by the administrator of the IBOR, it may be made by any of the following persons or entities:

  • the regulatory supervisor for the administrator of the IBOR;
  • the central bank for the currency of the IBOR;
  • an insolvency official with jurisdiction over the administrator for the IBOR;
  • a resolution authority with jurisdiction over the administrator for the IBOR;
  • a court; or
  • an entity with similar insolvency or resolution authority over the administrator for the IBOR.

Subparagraph (h)(5) defines an associated modification as a modification of the technical, administrative, or operational terms of a contract that is necessary to adopt or implement the modifications (other than associated modifications) described as a covered modification in subdivisions (h)(1)(i)-(iii).

An associated modification also includes an incidental cash payment intended to compensate a counterparty for small valuation differences caused by a modification of a contract’s administrative terms, like the valuation differences caused by a change in the observation period. Examples of associated modifications include a change to the definition of an interest period and to the timing and frequency of determining rates and making interest payments. A particular example described in the regs is delaying payment dates on a debt instrument by two days to allow sufficient time to compute and pay interest at a qualified rate computed in arrears.

Subparagraph (h)(6) defines qualified one-time payment as a single cash payment that is intended to compensate the other party or parties for all or part of the basis difference between the discontinued IBOR identified in subdivisions (h)(1)(i)-(iii) and the interest rate benchmark to which the qualified rate refers.

Covered Modification Exclusions

Paragraph (j) addresses contract modifications that are excluded from the definition of covered modification and will be the subject of a future article. A modification or portion of a modification described in any of subparagraphs (j)(1)-(5) is excluded from the definition of covered modification in subparagraph (h)(1) and is therefore a noncovered modification. Subparagraph (j)(6) provides seven examples that illustrate the exclusions to covered modification.

Applicability Dates

Paragraph (k) provides applicability dates. Reg. section 1.1001-6 applies to a contract modification that occurs on or after March 7, 2022. A taxpayer may choose to apply these rules to modifications that occur before that date, provided that the taxpayer and all related parties apply this section to all modifications that occur before that date (see section 7805(b)(7)). Related parties are defined by reference to sections 267(b) and 707(b)(1); and reg. section 1.150-1(b) for state or local governmental units (as defined in reg. section 1.103-1(a)) and section 501(c)(3) organizations (as defined in section 150(a)(4)).

Preamble

Although the final and proposed regs share many of the same rules, the structure of reg. section 1.1001-6 in the final regs differs from the proposed regs. These structural changes are intended to simplify the operative rules in reg. section 1.1001-6.

For example, while the proposed regs separately state the rules for debt and nondebt contracts, the final regs provide a single set of rules for all contracts. Moreover, the final regs define contract broadly to include not only debt instruments and derivative contracts but also insurance contracts, stock, leases, and other contractual relationships. The final regs also use defined terms (in reg. section 1.1001-6(h)) to streamline references to concepts that are frequently used in the operative rules.

The term “covered modification” is the cornerstone of the final regs that restructures several of the rules in the proposed regs. For example, prop. reg. section 1.1001-6 generally provides beneficial tax consequences when parties modify a contract to replace an IBOR-based rate with a qualified rate and make associated modifications that include a one-time payment. The final regs unite these terms in the proposed regs under the covered modification concept defined in subparagraph (h)(1).

Section 1001 Treatment

Prop. reg. section 1.1001-6(a) generally provides rules for applying section 1001 to a contract that is modified to replace an IBOR-based rate or IBOR-based fallback provisions, or to add or amend fallback provisions that would replace an IBOR-based rate. Prop. reg. section 1.1001-6(a) generally provides that these modifications are not treated as an exchange of property under section 1001 and extends this treatment to conforming modifications.

When modifications that qualify for this special treatment under prop. reg. section 1.1001-6(a) occur contemporaneously with modifications that do not qualify, the nonqualifying modifications are subject to the ordinary rules in prop. reg. section 1.1001-1(a) or -3. The modifications that qualify for special treatment under prop. reg. section 1.1001-6(a) are treated as part of the existing terms of the contract. Section 1.1001-6(b) of the final regs provides similar rules but instead distinguishes between covered and noncovered modifications.

Covered and Noncovered Modifications

Under reg. section 1.1001-6(b)(1), a covered modification of a contract is not treated as an exchange of property for other property differing materially in kind or extent under reg. section 1.1001-1(a). Consequently, in the case of a debt instrument, a covered modification to which reg. section 1.1001-6(b)(1) applies is not treated as a significant modification under reg. section 1.1001-3.

A covered modification is defined in reg. section 1.1001-6(h)(1) as containing four elements:

  • a contract with an operative rate or fallback provision that references a discontinued IBOR;
  • a modification of that contract in one of three ways as described in subdivision (h)(1)(i)-(iii);
  • modifications associated with the modifications of the operative rate or fallback provisions; and
  • satisfaction of rules in reg. section 1.1001-6(j) that exclude some modifications from the definition of covered modification.

The three modifications in the second prong of the test qualify only if they modify the contract:

  • to replace an operative rate that refers to a discontinued IBOR with a qualified rate and (if the parties agree) to add an obligation for one party to make a qualified one-time payment;
  • to include a qualified rate as a fallback to an operative rate that refers to a discontinued IBOR; or
  • to replace a fallback rate that refers to a discontinued IBOR with a qualified rate.

A modification described in section 4.02 of Rev. Proc. 2020-44 is also treated as a covered modification.

Modification is broadly construed to include any modification, regardless of its form. For example, a holding corporation that issued preferred stock may modify that stock by means of an exchange offer conducted by the corporation’s subsidiary.

The term also includes any modification regardless of whether it is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. For example, any agreement to make additional payments under a contract is a modification of that contract, regardless of whether the parties memorialize the obligation to make those payments in an amendment to the original contract or in a new, stand-alone contract.

Reg. section 1.1001-6(b)(1) generally provides that a covered modification is not treated as an exchange of property for other property differing materially in kind or extent under reg. section 1.1001-1(a). However, whether a noncovered modification that occurs contemporaneously with a covered modification is an exchange of property is determined under the ordinary rules in reg. section 1.1001-1(a) or -3.

The final regs define a noncovered modification as any modification or portion of a modification that is not a covered modification, indicating that a modification is a noncovered modification only to the extent that it fails to be a covered modification. Therefore, a modification that qualifies for beneficial treatment may be paired with a modification that doesn’t qualify without preventing the qualifying modification from benefiting from the proposed regs.

After a covered modification by which the parties add or amend fallback provisions, the change to the contract terms that results from the activation of the new fallback provisions must be tested separately at the time of activation to determine whether the change is an exchange of property under reg. section 1.1001-1(a).

If the change resulting from the activation of a fallback is a covered modification under reg. section 1.1001-6(h)(1), then the special rules in the final regs for covered modifications apply to that change. Otherwise, whether that change is an exchange of property for other property differing materially in kind or extent is generally determined under reg. section 1.1001-3 for debt instruments and reg. section 1.1001-1(a) for other kinds of contracts.

Discontinued IBOR

Reg. sections 1.1001-6(h)(4), 1.860G-1(e), and 1.1275-2(m) provide a definition of discontinued IBOR that does not appear in the proposed regs. A discontinued IBOR is generally an IBOR that will be discontinued; and an IBOR ceases to be a discontinued IBOR a year after the IBOR’s discontinuation. The new definition tailors the relief provided in the final regs to better match the problem that the final regs are intended to address.

The purpose of the final regs is to facilitate the transition away from discontinued IBORs to avoid the market disruption that may occur if parties to contracts referencing discontinued IBORs fail to transition before the discontinued IBOR ceases. Moreover, the discontinuation of the most commonly used tenors of U.S. dollar LIBOR has been deferred until June 30, 2023, giving parties an additional 18 months to act.

The ICE Benchmark Administration will continue to publish synthetic pound-sterling and yen LIBORs for a limited time after December 31, 2021, and may publish synthetic U.S. dollar LIBORs for a limited time after June 30, 2023.

Under the final regs, the synthetic LIBORs are a continuation of the currency and tenor variant of LIBOR that they succeed. For example, a three-month sterling LIBOR became a discontinued IBOR on March 5, 2021, the date on which the ICE Benchmark Administration announced that it would permanently cease to publish three-month sterling LIBOR. It will cease to be a discontinued IBOR one year after the date on which the ICE Benchmark Administration ceases to publish the three-month tenor of synthetic pound-sterling LIBOR.

Associated Modifications

The proposed regs generally define an associated modification as a modification that is both associated with the replacement of an IBOR-based rate or the inclusion of fallbacks to an IBOR-based rate and is reasonably necessary to adopt the replacement rate or to implement the fallback inclusion.

Section 1.1001-6(h)(5) of the final regs generally defines an associated modification similarly but eliminates the requirement that an associated modification be associated with a replacement or inclusion because any modification that is necessary to adopt or implement the replacement or inclusion is always associated with that replacement or inclusion.

The definition of associated modification in the proposed regs also includes a one-time payment, which is generally defined as a payment to offset the change in value of the contract that results from replacing an IBOR-based rate with a qualified rate.

A commentator asked whether some cash payments can qualify as associated modifications even if they are not one-time payments. An example assumes the parties to an interest rate swap agree to replace U.S. dollar LIBOR with a replacement rate comprising a compounded average of SOFR (computed in arrears using a two-day observation period shift without payment lag) and a fixed adjustment spread. One party might also agree to make a cash payment to compensate the counterparty for small valuation differences between the modification LIBOR-based contract and the post-modification SOFR-based contract, like the valuation differences caused by the different observation period.

Treasury and the IRS have concluded that including these limited payments within the definition of an associated modification would further the policy goal of the final regs to facilitate the transition away from discontinued IBORs. Therefore, the definition of associated modification in reg. section 1.1001-6(h)(5) includes an incidental cash payment intended to compensate a counterparty for small valuation differences caused by modification of a contract’s administrative terms, like the valuation differences caused by a change in observation period. Treasury and the IRS caution, however, that a payment of an amount that is not incidental cannot qualify as an associated modification.

Qualified One-Time Payments

The proposed regs define a one-time payment as a payment offsetting the change in value of a contract caused by replacing an IBOR-based rate with a qualified rate that may be an associated modification. To improve readability and clarity, the final regs redesignate one-time payments as qualified one-time payments and include the new term in a stand-alone definition rather than as a type of associated modification.

Commentators suggested a cap on the amount of a one-time payment and described abuses that may result if the amount of the payment is not limited in some way. To clarify the intent of the proposed regs and to prevent excessive payments from satisfying the definition of qualified one-time payments, the final regs in subparagraph (h)(6) generally limit a qualified one-time payment to the amount intended to compensate for the basis difference between the discontinued IBOR and the interest rate benchmark to which the qualified rate refers. Any portion over that cap is a noncovered modification.

Prop. reg. section 1.1001-6(d) provides that the character and source of a one-time payment is the same as the character and source of any payment under the contract by the same payer. For example, a one-time payment by a lessee on a lease is characterized as a payment of rent and sourced accordingly.

Treasury and the IRS received several comments requesting clarification on how this proposed rule applies to financial contracts and on the timing of tax items associated with a one-time payment. One commentator requested guidance on how a one-time payment is treated under the arbitrage investment and private-use restrictions that apply to tax-advantaged bonds. Treasury and the IRS are still considering how to address these issues relating to qualified one-time payments.

Until Treasury and the IRS publish further guidance, taxpayers may continue to rely on the rule in prop. reg. section 1.1001-6(d) to determine source and character of a qualified one-time payment under the final regs.

Rev. Proc. 2020-44

In Rev. Proc. 2020-44, Treasury and the IRS provide rules that overlap with some of the rules in the final regs. Like reg. section 1.1001-6(b)(1) of the final regs, section 5.01 of Rev. Proc. 2020-44 provides that a modification within the scope of the revenue procedure is not treated as an exchange of property for other property differing materially in kind or extent for purposes of reg. section 1.1001-1(a). Like reg. section 1.1001-6(c)(1)(iii) and (c)(2) of the final regs, section 5.02 of the procedure generally provides that a modification within the scope of the procedure will not result in legging out of an integrated transaction or terminating either leg of a hedging transaction.

Section 4.02 of Rev. Proc. 2020-44 generally limits the scope of the revenue procedure to contract modifications that incorporate fallback provisions published by the ARRC or ISDA. The parties modifying a contract under the procedure may also deviate in limited ways from the ARRC and ISDA fallbacks. The scope of the procedure may be expanded in subsequent guidance to address developments in the transition away from IBORs. The revenue procedure applies to modifications that occur between October 9, 2020, and January 1, 2023, although parties to a contract may rely on the revenue procedure for modifications that occurred before October 9, 2020.

The definition of covered modification in reg. section 1.1001-6(h)(1) generally provides that a modification described in section 4.02 of Rev. Proc. 2020-44 is treated as a covered modification. This is true even if the revenue procedure does not apply to that modification, for example, because it occurs after the revenue procedure’s December 31, 2022, sunset date. The effect of this provision is that the rules in reg. sections 1.1001-6(b)(g) and 1.860G-1(e), which rely on the definition of covered modification in reg. section 1.1001-6(h)(1), apply to modifications described in section 4.02 of Rev. Proc. 2020-44.

Because of the substantive overlap between the rules in reg. section 1.1001-6(b) and (c) and the rules in section 5 of Rev. Proc. 2020-44, it is possible for a single modification to be subject to both sets of rules. As a practical matter, however, the rules in reg. section 1.1001-6(b) and (c) are consistent with the rules in section 5 of Rev. Proc. 2020-44, so no conflict is expected to arise.

Before the release of Rev. Proc. 2020-44, several commentators recommended that the final regs accommodate the fallback provisions published by the ARRC and ISDA. One commentator recommended that the final regs provide that a modification to incorporate the ARRC’s or ISDA’s fallback or similar provisions is not an exchange of property under section 1001. The final regs’ reference to Rev. Proc. 2020-44 in the definition of covered modification addresses these comments.

Fast-Pay Stock

Reg. section 1.7701(l)-3 provides rules that prevent the avoidance of tax by persons participating in fast-pay arrangements. A fast-pay arrangement is defined in reg. section 1.7701(l)-3(b)(1) as any arrangement in which a corporation has fast-pay stock outstanding for any part of its tax year. Fast-pay stock is defined in reg. section 1.7701(l)-3(b)(2)(i) as stock structured so that dividends (as defined in section 316) paid by the corporation to the stockholders are economically (in whole or in part) a return of the holder’s investment (as opposed to only a return on the holder’s investment).

Reg. section 1.7701(l)-3(b)(2)(ii) provides that the determination of whether stock is fast-pay stock is based on all facts and circumstances. Stock is examined when it is issued to determine if it is fast-pay stock. If it is not fast-pay stock when issued, it is examined when there is a significant modification in the terms of the stock or related agreements, or a significant change in the relevant facts and circumstances.

A covered modification of preferred stock could cause the stock to satisfy the definition of fast-pay stock even though the parties modify the stock not to avoid tax, but to address the discontinuation of an IBOR. A commentator recommended that a covered modification be treated as neither a significant modification nor a significant change in circumstances. Treasury and the IRS have determined that this rule would facilitate transition away from discontinued IBORs. Moreover, the scope and operation of the suggested rule is generally consistent with the rules in reg. section 1.1001-6(b)(1) and (d) (treatment of covered modifications under section 1001 and chapter 4).

Accordingly, reg. section 1.1001-6(e) provides that a covered modification of stock is not a significant modification in the terms of the stock or related agreements, or a significant change in the relevant facts and circumstances under reg. section 1.7701(l)-3(b)(2)(ii).

Unlike reg. section 1.1001-6(b)(1) and (d), however, reg. section 1.1001-6(e) further provides that, if a covered modification and a noncovered modification are made at the same time or as part of the same plan, and the noncovered modification is a significant modification in the terms of the stock or the related agreements or a significant change in facts and circumstances, then reg. section 1.7701(l)-3(b)(2)(ii) applies and all of the facts and circumstances, including the covered and noncovered modification, are considered in determining whether the stock is fast-pay stock.

Investment Trusts

Under reg. section 301.7701-4(c)(1), an investment trust is not classified as a trust if there is power under the trust agreement to vary the investment of the certificate holders. One commentator recommended that a covered modification of the income apportioning terms of an ownership interest be treated as not manifesting a power to vary the investment of certificate holders in a trust. Reg. section 1.1001-6(f) provides that neither a covered modification of a contract held by an investment trust, nor of an ownership interest in the investment trust, manifests a power to vary the investment of the certificate holder under reg. section 301.7701-4(c)(1).

Foreign Corporation Interest Expense

The preamble contains a discussion of transition away from discontinued IBORs and interest expense of a foreign corporation. Prop. reg. section 1.882-5(d)(5)(ii)(B) provides that a foreign corporation that is a bank may elect to compute interest expense attributable to excess U.S.-connected liabilities using a yearly average of SOFR. One commentator said that interest rate is not an equitable substitute for 30-day U.S. dollar LIBOR, the rate that foreign banks are permitted to elect for this purpose under the existing regs, because 30-day U.S. dollar LIBOR is typically a higher rate than a yearly average of SOFR.

This commentator recommended that, in lieu of SOFR, the final regs either refer to a widely accepted interest rate benchmark that is more similar than SOFR to 30-day U.S. dollar LIBOR or add a fixed adjustment spread to the yearly average of SOFR. Treasury and the IRS continue to study the appropriate rate to replace 30-day U.S. dollar LIBOR for purposes of the published rate election under reg. section 1.882-5(d)(5)(ii)(B).

In evaluating the appropriate replacement rate, Treasury and the IRS will continue to balance the administrative convenience of providing taxpayers an election to use the annual published rate with the need for a replacement rate that more accurately reflects the taxpayer’s borrowing costs. In providing taxpayers with an election to use a published rate, Treasury and the IRS must ensure that the replacement rate does not overstate the amount of interest expense allocable to income that is effectively connected to a U.S. trade or business.

Until final regs replace the 30-day U.S. dollar LIBOR election provided in reg. section 1.882-5(d)(5)(ii)(B), taxpayers may continue to apply either the general rule or the annual published rate election provided under reg. section 1.882-5(d)(5)(ii) to calculate interest on excess U.S.-connected liabilities. Taxpayers may also continue to rely on the rule in prop. reg. section 1.882-5(d)(5)(ii)(B) and compute interest on excess U.S.-connected liabilities by computing a yearly average SOFR based on the rates published by the Federal Bank of New York for the tax year.

Although commentators provided some ideas on a rate that could be closer to a replacement for 30-day LIBOR (for example, a widely accepted interest rate benchmark or adding a fixed adjustment spread to the yearly average of SOFR), Treasury and the IRS continue to request recommendations for a specific rate that would be an appropriate replacement for the 30-day LIBOR for computing interest expense on excess U.S.-connected liabilities under reg. section 1.882-5(d)(5)(ii)(B). Treasury and the IRS anticipate issuing additional guidance addressing reg. section 1.882-5(d)(5)(ii)(B) before 30-day U.S. dollar LIBOR is discontinued in 2023.

Change of Accounting Method

One commentator asked Treasury and the IRS to address whether changing from an IBOR-based discount rate to a discount rate based on a different interest rate benchmark to value securities under the mark-to-market rules in section 475 is a change in accounting method that requires the consent of the secretary under section 446(e). The commentator noted that this change may occur either when the relevant IBOR is discontinued or before that time in anticipation of its discontinuation.

To facilitate an orderly transition in connection with the discontinuation of IBORs and to treat changes from an IBOR-based discount rate in a consistent manner, Treasury and the IRS will not treat a change from a discount rate that is based on a discontinued IBOR (as defined in reg. section 1.1001-6(h)(4)) to a discount rate that is a qualified rate to value securities under the mark-to-market rules in section 475 as a change in accounting method requiring consent under section 446(e).

Necessity and Economic Analysis

The preamble includes a discussion of the necessity and economic impact of the new regs. A large volume of U.S. financial products and contracts include terms or conditions that reference LIBOR or IBORs. Concern about manipulation and a decline in the volume of funding from which LIBOR is calculated led to recommendations for the development of alternatives to LIBOR that would be based on transactions in a more robust underlying market.

Also, on July 27, 2017, the Financial Conduct Authority announced that all currency and term variants of LIBOR, including U.S. dollar LIBOR, may be phased out after 2021 and no longer be published.

The administrator of LIBOR announced March 5, 2021, that publication of overnight, one-month, three-month, six-month, and 12-month U.S. dollar LIBOR will cease immediately after the LIBOR publication on June 30, 2023, and that publication of all other currency and tenor variants of LIBOR will cease immediately after the LIBOR publication on December 31, 2021.

The ARRC, a group of stakeholders affected by the cessation of the publication of U.S. dollar LIBOR, was convened to identify an alternative rate and to facilitate voluntary adoption of it. The ARRC recommended SOFR as a potential replacement for U.S. dollar LIBOR. Essentially all financial products and contracts that currently contain conditions or legal provisions that rely on LIBOR and other IBORs are expected to transition to SOFR or similar alternatives in the next few years. This transition will involve changes in debt, derivatives, and other financial contracts to adopt SOFR or other alternative reference rates.

The ARRC has estimated that the total exposure to U.S. dollar LIBOR was close to $200 trillion in 2016, of which approximately 95 percent were in over-the-counter derivatives. ARRC further notes that U.S. dollar LIBOR is also referenced in several trillion dollars of corporate loans, floating-rate mortgages, and similar financial products. In the absence of further tax guidance, the expected changes in these contracts could lead to the recognition of gains or losses under U.S. tax law and potentially large tax liabilities for their holders.

To address this issue, the final regs provide that changes in debt instruments, derivative contracts, and other affected contracts to replace reference rates based on discontinued IBORs in a covered modification (as defined in the final regs) will not result in tax realization events under section 1001 and regs. A covered modification is generally the replacement of a discontinued IBOR with a qualified rate, provided that the replacement is not excluded under reg. section 1.1001-6(j)(1)(5).

The excluded modifications ensure that a covered modification includes only modifications to the cash flows of an IBOR-referencing contract intended to address the replacement of the IBOR-based rate in the contract. Modifications intended to change the amount or timing of cash flows for other reasons or purposes remain subject to the general rules in section 1001 and regs.

The final regs also provide corresponding guidance on hedging transactions and derivatives to the effect that taxpayers may modify the components of hedged or integrated transactions to replace discontinued IBORs in a covered modification without affecting the tax treatment of the hedges or underlying transactions.

In the absence of these final regs, parties to contracts affected by the cessation of the publication of LIBOR would either suffer tax consequences to the extent that a change to the contract causes a tax realization event under section 1001 or attempt to find alternative contracts that avoid a tax realization event, which may be difficult as a commercial matter. Both options would be costly and highly disruptive to U.S. financial markets.

A large number of contracts may be breached, which may lead to bankruptcies or other legal proceedings. The types of actions that contract holders might take in the absence of these final regs are difficult to predict because that event is outside recent experience in U.S. financial markets. This financial disruption would be particularly unproductive because the economic characteristics of the financial products and contracts under the new rates would be essentially unchanged. Therefore, there is no economic rationale for a tax realization event.

Treasury and the IRS project that these final regs would avoid this costly and unproductive disruption. Treasury and the IRS further project that these final regs, by implementing the regulatory provisions requested by ARRC and taxpayers, will help facilitate the economy’s adaptation to the cessation of LIBOR in the least-costly manner.

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