If you have loans, hedges or other financial instruments that use the London Interbank Offered Rate (LIBOR) or reference it in some manner, the rate will no longer be used in most cases after Dec. 31, 2021. That means you will be changing the terms (interest rates and terms) on existing loans. But doing this, if it involves significant modifications to the debt, it will potentially trigger gains or losses under Section 1001.
So, you must be careful in how these terms are modified, the rates to be used and any changes in payment terms. The final regulations generally provide for modifications in anticipation of the elimination of LIBOR is not treated as an exchange of one property for another, triggering gain or loss. The changes can not be because of financial distress by the lender or the borrower, resulting in new terms not equivalent to the original LIBOR terms.
History of LIBOR Change
Following a scandal that erupted in 2012 concerning the routine manipulation of the LIBOR by traders and several major banks to increase their profits, regulators had pressed banks to develop alternatives to LIBOR. A large number of financial products and contracts, including loans, reference LIBOR in setting interest rates. Then, on July 27, 2017, the U.K. Financial Conduct Authority (authority tasked with overseeing LIBOR) announced all currency and term variants of LIBOR, including USD LIBOR, would be phased out after 2021.
The Alternative Reference Rate Committee (ARRC) was convened to identify alternative reference rates that would be more robust and comply with certain standards not observed under the LIBOR regime. As you would expect, this transition results in tax and other issues when loans are adjusted and use new reference rates other than LIBOR.
Proposed and now final Internal Revenue Service (IRS) regulations have been issued related to these changes. Rev. Proc. 2020-44, that was issued after the proposed regulations, provided guidance in advance of finalizing these regulations. This guidance can be used for modifications that occur on or after Oct. 9, 2020, and before Jan. 1, 2023. The final regulations may also be used retroactively, as long as used consistently.
Significant Modification of Debt Triggers Gain or Loss
Under present rules, debt instruments that are significantly modified result in the debt being considered sold and new debt incurred, which triggers taxable gain or loss. Final regulations allow for changes from LIBOR to a qualified rate, provided the fair market value of the debt is not altered. The new “qualified rate” includes the following (not necessarily an exclusive list):
1. Secured Overnight Financing Rate (SOFR)-US
2. Sterling Overnight Index Average (SONIA)-UK
3. Swiss Average Rate Overnight (SARON)-Switzerland
4. Euro Short-Term Rate (€STR)-EEU
5. Tokyo Overnight Average Rate (TONA)-Japan
It is envisioned that certain one-time payments may be made by one of the parties (lender or borrower) in connection with this modification. This associated alternation or modification is not a problem if associated with a change in the referencing rate and is to keep the fair market values of both instruments (pre- and post- LIBOR notes) equal. The final regulations unite the various elements in the proposed regulations (modification of a contract, qualified rate, associated modifications and a qualified one-time payment) into the single defined term “covered modification”. A covered modification is generally comprised of these four elements and is detailed in Reg. Sec. 1.1001-6(h)(1).
While the regulations address the source and character of the one-time payment, they do not address when the payment is recognized in taxable income. The source and character of the payments were not finalized and are still in proposed form (see Reg. Sec. 1.1001-6(d)).
Safe Harbor in Meeting Fair Market Value (FMV) Requirement
Two safe harbors were provided in meeting the FMV requirement under the proposed regulations. One was the historic average of the LIBOR-referencing rate is within 25 basis point (1/4 of 1%) of the qualified rate that replaces it. Because of difficulties with the second proposed safe harbor, the IRS has provided rules in the final regulations that describe specific modifications (the excluded modifications) and exclude those modifications from the definition of covered modifications (kind of modifications to avoid).
Financial Statement Issues-FASB
The Financial Accounting Standards Board (FASB) proposed an account standard update in September to aid with the transition to the new rate. The final guidance was approved by the FASB on Nov. 13, 2019, and will provide optional expedients and exceptions for applying GAAP to any modifications. More information can be found on their website.
Change in Accounting Method
The IRS will not consider a change in the rate used under the mark-to-market rules in Sec. 475 to be a change in method of accounting.
Moore Doeren Mayhew can help you determine the reference rates to be used and what types of one-time payments might be appropriate. We would be pleased to discuss these issues with you as you determine what loans it might apply to in your situation. Contact our international tax advisors today.
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