�鶹ֱ��

On October 9, 2019, the United States Treasury Department published proposed regulations that address the federal tax consequences of the expected phase-out of the London interbank offered rate (LIBOR) after 2021 and possible elimination of all interbank offered rates (IBORs). The intent of these regulations generally is to provide federal tax relief that minimizes the economic impact of the elimination of IBORs, including LIBOR.

The proposed regulations address both debt instruments and other financial instruments (such as derivatives) that reference an IBOR, such as a debt instrument providing for interest based on U.S. dollar LIBOR.

Immediate Application Permitted

The proposed regulations can be applied immediately and regardless of whether, or when, LIBOR is actually phased out. They provide relief for debt instruments and other financial instruments that are changed from IBOR-referencing rates in anticipation of the expected phase out. Moreover, they provide the parties can choose to apply the regulations immediately (although the parties are not required to do so). For example, the proposed regulations provide that, with respect to debt instruments, taxpayers may choose to apply the proposed regulations to any alteration that occurs before the date of publication of final regulations.

The proposed regulations generally would be required to be applied after the date of publication of final regulations. The exact wording of the effective date differs somewhat depending on the type of financial instrument.

Sale or Exchange (“Reissuance”) of Debt Instruments

General Overview.  The Internal Revenue Code (the Code) and the Treasury Regulations provide that a significant modification of a debt instrument generally results in a sale or exchange of the debt instrument (that is, the debt instrument prior to the modification is deemed to be exchanged for a deemed new debt instrument with the modified terms). A tax reissuance can have a number of federal tax consequences, including possibly requiring the parties to recognize income, deduction, gain or loss, and making the debt instruments subject to changes in the provisions of the Code or Treasury Regulations made subsequent to the date of original issuance. In the case of tax-advantaged obligations, a tax reissuance generally is treated as the issuance of a new refunding issue, which must be retested for compliance with the applicable federal tax requirements. The proposed regulations provide a path to avoid such tax consequences.

The proposed regulations generally provide that a change from an IBOR-referencing rate to another rate will not result in a tax reissuance if the fair market value of the debt instrument after the alteration is substantially equivalent to the fair market value of the debt instrument before the alteration. The proposed regulations provide two safe harbors for this purpose. The proposed regulations also permit certain associated alterations including the obligation of one party to make a one-time payment in connection with the replacement.

“Qualified Rates” and Safe Harbors.  The proposed regulations more specifically provide that an alteration of the terms of a debt instrument to replace a rate referencing an IBOR with a “qualified rate” and any “associated alteration” are not treated as modifications and therefor do not result in a tax reissuance. Similarly, the proposed regulations provide that alteration of a debt instrument to include a qualified rate as a fallback (or substitute a qualified rate in place of a rate referencing IBOR) and any associated alterations are not treated as modifications and therefor do not result in a tax reissuance.

A “qualified rate” is broadly defined to include (1) the Secured Overnight Financing Rate (SOFR), (2) any rate selected, endorsed or recommended by the central bank, reserve bank, monetary authority or similar institution (including a committee or working group thereof) as a replacement for IBOR or its local currency equivalent, and (3) any “qualified floating rate” as defined in Treasury Regulations relating to the original issue discount rules. In addition, a rate is a qualified rate only if the fair market value of the debt instrument after the alteration is substantially equivalent to the fair market value of the debt instrument before the alteration and currency (or is reasonably expected to measure contemporaneous variations in the same currency).

The proposed regulations set forth two different safe harbors to meet the “substantially equivalent fair market value requirement.”

Valuation Safe Harbor Based on Comparison of Historic Rates.  The first safe harbor is based on a comparison of historic average rates. The safe harbor is met if the historic average of the original rate does not differ by more than 25 basis points from the historic average of the replacement rate (taking into account any one-time payment that is made in connection with the alteration). The proposed regulations flexibly permit any reasonable method to be used in this comparison provided that the method takes into account every instance of the relevant rate published during a continuous period that begins no earlier than 10 years before the alteration and ends no earlier than 3 months before the alteration. The ability to select any historic period not greater than 10 years for purposes of this comparison makes this historic comparison rule particularly flexible (for example, if the historic average test is met over a six-month period before the alteration, but no other period, the test would be met).

Valuation Safe Harbor Based on Arm’s Length Negotiations.  The second safe harbor is met if the parties to the debt instrument are not related and they determine, based on bona fide, arm’s length negotiations between the parties, that the fair market value of the debt instrument before the alteration is substantially equivalent to the fair market value after the alteration. For this purpose, the fair market value of the debt instrument must take into account the value of any one-time payment that is made in connection with the alteration.

Associated Alterations Permitted.  The proposed regulations provide that any “associated alteration” made in connection with the permitted replacement of a rate referencing IBOR is also not a modification. An associated alteration is broadly defined as any alteration “that is reasonably necessary to adopt or to implement that replacement or inclusion.” An associated alteration may be a technical, administrative, or operational modification, such as a change to the definition of interest period or a change to the timing and frequency of determining rates and making payments of interest. An associated alteration may also be the addition of an obligation of one party to make a one-time payment in connection with the replacement of an IBOR-referencing rate to offset the change in value of the debt instrument that results from that replacement. Many technical, administrative, or operational modifications permitted under the proposed regulations would likely not result in reissuance because they would not be significant modifications. The proposed regulations helpfully provide, however, that such changes do not need to be tested for significance at all. An alteration providing for a one-time payment, on the other hand, in many cases would otherwise result in a reissuance, depending on the amount of the payment. In that respect, the provision providing for the one-time payment could be viewed as providing particular flexibility.

The proposed regulations provide that the source and character permitted one-time payment will be treated as “the same as the source and character that would otherwise apply to a payment made by the payor.”

Some Observations on the Valuation Safe Harbors.  The proposed regulations provide that, in determining whether the “substantially equivalent value” requirement is met, the parties may use any reasonable consistently applied valuation method. Accordingly, taxpayers are not required to use either of the safe harbors, but may establish that the test is met based on other methods. The proposed regulations provide that the IRS may set forth additional safe harbors in future published guidance.

In cases where the parties seek a high degree of confidence in the tax position, however, the parties will likely seek to meet one of the two safe harbors. In that context, and if tax opinions are required, certifications or formal determinations regarding compliance with one of the safe harbors may be commonplace. The safe harbor based on arm’s length negotiations has the appeal of apparent simplicity. It may be, however, that certain parties will be reluctant to provide certifications regarding fair market value of a financial instrument, or may require a background analysis to do so, particularly because there is some ambiguity regarding what “substantially equivalent” value standard means. The safe harbor based on historic average of rates has the appeal of being based on objective data and flexibility (because the period for comparison may be flexibly chosen). Such a certification will, however, require an analysis of data and, particularly if a one-time payment is involved, computations to adjust for the one-time payment.

Particularly because the test based on historic average rates may be flexibly applied, a debt instrument with a permitted replacement rate under this test will not necessarily in fact be closely equivalent to the fair market value of the debt instrument with the original IBOR-referencing rate. That appears to mean that the proposed regulations in effect could permit some degree of renegotiation to in substantially lower or increase interest rates, if the new rates meet the historical average test.

Tax Planning Opportunities.  Although the proposed regulations are primarily intended to provide relief from adverse tax consequences, they also present a number of possible tax planning opportunities.

At least until final regulations are published and become effective, taxpayers can choose to apply the proposed regulations, but are not required to do so. Under the proposed regulations the parties could choose to treat many transactions as either resulting in a tax reissuance or not resulting in a tax reissuance. In addition, the provision permitting a one-time payment to be treated as not a modification may present particular tax planning opportunities, particularly because the amount of the one-time payment is not expressly limited.

Treatment of Other Alterations.  The proposed regulations helpfully provide that the covered alterations made in connection with providing for a replacement of an IBOR-referencing rate are not treated as “modifications” at all under the applicable debt modification regulations. The debt modification regulations set forth a two part test. First, an alteration must be tested to determine whether it is treated as a “modification”. Second, a modification (and all other modifications of the same type) are cumulatively tested to determine whether they are “significant.” The proposed regulations provide relief under the first test, so that the significance of an alteration does not need to be considered. This liberal approach has a number of implications. Perhaps most importantly, any additional alterations to a debt instrument (not expressly covered by the proposed regulations) are tested by taking the debt instrument, as altered to the extent covered by the proposed regulations, as the baseline.

Treatment of Derivatives and Other Non-Debt Contracts

The proposed regulations provide rules for derivatives and other non-debt contracts to replace an IBOR-referencing rate that are comparable to the rules for debt instruments. In general, under these provisions, a derivative or other non-debt contract is not treated as terminated because of a permitted replacement of the IBOR-referencing rate, and hedging treatment for federal tax purposes is preserved.

Application in Other Special Cases

The proposed regulations provide additional relief in other special cases (for example, under the rules for REMICs and under the original issue discount rules that apply to debt instruments).

Special Considerations for Tax-Exempt and Other Tax-Advantaged Bonds

The proposed regulations generally apply for all federal income tax purposes and, with only one limited exception, do not address the special considerations that apply to tax-exempt bonds and other tax-advantaged bonds.

Treatment of One-Time Payment.  The provision permitting a one-time payment to be made in connection with the replacement of LIBOR-referencing rate raises special questions, and may present special opportunities, when applied to tax-exempt bonds. The proposed regulations provide that for all purposes of the Code, the “source and character” of such a one-time payment is “the same as the source and character that would otherwise apply to a payment made by the payor with respect to the debt instrument.” This appears to mean that a one-time payment to the holder will generally be treated as tax-exempt interest (in effect paid on an accelerated basis).

On the other hand, it is also possible that an interest rate replacement could be structured so that the holder makes a one-time payment to the issuer (such that the interest rate is higher than it otherwise would have been). The preamble to proposed regulations states that “the Treasury Department and the IRS expect that . . . one-time payments with respect to a debt instrument will generally not be paid by the lender to the borrower.” The reason for this statement is that the Treasury Department expects that LIBOR will generally be replaced with a lower, nearly risk-free rate, such as SOFR. Although this may be the case for most debt instruments, it will not always be the case, particularly for tax-advantaged bonds, particularly in light of the special tax rules that apply to tax-advantaged bonds.

The preamble to the proposed regulations indicates that the proposed regulations are intended to be silent on the question of the treatment of one-time payment received by an issuer, and request comments if it is determined that guidance is needed. Accordingly, the proposed regulations do not expressly address whether or when the one-time payment received by an issuer of tax-exempt bonds would need to be subject to the special restrictions that apply to proceeds and gross proceeds of tax-exempt bonds. For example, in the case of governmental bonds, the proposed regulations do not address whether the one-time payment could be treated as gross proceeds subject to the arbitrage restrictions on investments or as proceeds subject to restrictions on private business use. Because the proposed regulations provide that the qualifying replacement of the LIBOR-referencing rate, including making a one-time payment, is not treated as resulting in a new deemed bond issue, they provide some basis for the position that no such restrictions should apply, or that, at most, only arbitrage restrictions should apply. Clarification of this point possibly will be provided in final regulations. The proposed regulations contain no “anti-abuse” rules, but are rather generally intended to be taxpayer favorable. Certain of the most important Treasury Regulations concerning the tax-exempt bond requirements, however, do contain anti-abuse rules. Evaluating the treatment of a one-time payment received by an issuer at least under those tax-exempt bond anti-abuse rules will be necessary.

Considerations for State Law Validity.  The proposed regulations are, of course, federal tax regulations, and do not concern whether any amendments to a debt instrument affect validity of the debt instrument under State and local law. For example, even if an altered debt instrument is not treated as a new obligation for federal tax purposes, it might be treated as a new obligation for purposes of State and local law. That point may seem obvious in most contexts, but in the context of tax-advantaged bonds a number of unique considerations apply.

First, if a State or local debt obligation is not treated as validly issued under State law, the IRS takes the view that the debt instrument does not qualify as tax-exempt. In the case of a conduit bond (such as a State or local bond issued to make a loan to a 501(c)(3) organization), the underlying obligation to pay the altered obligation could be valid and enforceable, but there could still be a problem if the conduit obligation of the State or local government is not valid.  Second, in a case where a State or local government receives a one-time payment, it is possible that the transaction would be treated as a new borrowing for purposes of State or local law, even if not so treated for federal tax purposes. In general, the significant flexibility of the proposed regulations may permit changes to a bond to be treated as not “modifications” for federal tax purposes, even though the changes may in fact be legally and economically more significant than has been the case in the past with other interest rate conversions.

Relationship to Special Federal Tax Guidance Concerning Reissuance of Tax-Exempt Bonds.  Existing IRS published guidance concerning reissuance of debt instruments sets forth a number of special rules concerning tax-exempt bonds. These special tax-exempt bond rules include special provisions under the so-called debt modification regulations and special rules for tax-exempt “qualified tender bonds” under proposed regulations under Section 150 of the Code and IRS Notices, including IRS Notice 2008-41 and proposed regulations concerning “qualified tender bonds” published on December 31, 2018. The proposed regulations do not address or explain the intersection of the provisions of the proposed regulations with those special rules.  The proposed regulations have a number of practical implications for how those special rules now apply, however, in particular for the special rules for qualified tender bonds.

IRS published guidance has long provided for special favorable reissuance rules for “qualified tender bonds.” These rules generally apply to bonds issued under multi-modal indentures that provide for a number of different alternative interest rates. The indentures generally provide that the issuer has the right to convert to a new interest rate, provided that the bonds are also subject to tender by the holder at the time of the interest rate conversion. Because a reissuance generally causes all of the tax-exempt bond requirements to be retested, the favorable IRS guidance has provided that such interest rate conversions do not result in a reissuance for the purposes of the issuer’s compliance with those requirements, subject to a number of conditions. One of the important conditions has been that the new rate generally must have been provided for in the bond documents on the date of issuance. Among other things, the proposed regulations in effect permit the use of certain replacement rates not present in the original bond documents.

Tax-Exempt Bond FAQs on the IRS Proposed Regulations on LIBOR Phase-out

If a tax-exempt bond is issued with a LIBOR-referencing interest rate, is a back-up rate necessary to avoid a tax reissuance if LIBOR is phased out?

No. The proposed regulations expressly provide a path for the parties to agree to a new replacement interest rate, without tax reissuance, provided that certain conditions are met. In particular, the bond with a replacement rate, and any associated alterations, must have a “substantially equivalent value” to the bond prior to the replacement. There may, of course, be other business considerations relating to whether providing for a back-up rate may be advisable.

What are the basic requirements for a replacement rate to qualify for the favorable treatment under the proposed regulations?

A permitted “qualified rate” under the proposed regulations must meet two tests concerning:  (1) the type of rate; and (2) whether the altered bond has “substantially equivalent value” to the original bond. The requirement relating to the type of rate should broadly include most types of customary variable interest rates, and includes SOFR and any “qualified floating rate.” The second requirement is that a rate is a “qualified rate” only if the fair market value of the debt after the alteration is “substantially equivalent” to the value of the debt before the alteration.

Can a permitted “qualified rate” be determined by adding or subtracting a specified number of basis points to or from a rate or by multiplying the rate by a specified number?

Yes.

Which of the two requirements for a replacement rate is most likely to raise practical issues?

Unless a rate contains unusual contingencies, the type of the rate probably will not be a practical concern in most cases. Documenting compliance with the “substantially equivalent value” test may, however, be a common practical concern.

How can the “substantially equivalent value” test in the proposed regulations be met?

The proposed regulations provide for two different safe harbors:  (1) a safe harbor based on comparison of a historic average of rates and (2) a safe harbor based on arm’s-length negotiations. Each of these requires specified certifications or determinations. An issuer may meet the “substantially equivalent value” test in other ways, but at this point only two safe harbors are provided.

How flexible is the “historic average of rates” value safe harbor?

The historic average of rates safe harbor is met if, on the date of the alteration, the historic average of the original LIBOR-referencing rate does not differ from the historic average replacement rate by more than 25 basis points. The safe harbor is very flexible because the parties can select any period beginning not earlier than 10 years before the date of the alteration and ending not earlier than three months before the alteration. Within those constraints, any period may be used (for example, any period from two days, or perhaps one day, to 10 years).

How flexible is the “arm’s length negotiations” value safe harbor?

The arm’s length negotiation safe harbor is met if the parties “determine, based on bona fide, arm’s length negotiations between the parties,” that the fair market value of the debt before the alteration is substantially equivalent to the fair market value after the alteration. This safe harbor is more flexible than the historic average of rates safe harbor in the sense that it does not expressly require assembling and comparing market data. As a practical matter, however, many parties may be reluctant to formally make a “determination” regarding fair market value, particularly because there is no clear guidance on what the “substantially equivalent” test means. Thus, parties making such a determination might in any event look to market data to make the determination.

Should the agreements for LIBOR-referencing debt without a backup rate now include provisions regarding possible future use of the valuation safe harbors?

Although the proposed regulations plainly provide a path for LIBOR-referencing debt to be altered to provide for a replacement rate without tax reissuance, in most cases it may be expected that avoiding tax reissuance will require meeting one of the safe harbors in the future.  This raises the question of whether the agreements for such debt should provide for an understanding that one of the safe harbors will be met in the future and, if so, how.

Does meeting a “substantially equivalent value” safe harbor in the proposed regulations necessarily establish that the new rate and the replacement rate in fact have equivalent values as a business matter?

No. The safe harbors are flexible to the point where meeting one of the safe harbors does not necessarily imply that, as a business matter, the new rate is equivalent in value to the original rate.

What other alterations are permitted in connection with the replacement of a LIBOR-referencing rate?

The proposed regulations flexibly provide that an “associated alteration” is not treated as a modification. An associated alteration is any alteration of a debt that is associated with the replacement of the LIBOR-referencing rate “that is reasonably necessary to adopt or implement that replacement or inclusion.” The proposed regulations provide that an associated alteration may include any technical, administrative, or operation alteration, such as a change to the definition of interest period or a change in timing and frequency of determining rates and making payments of interest. In addition, an associated alteration may be “an obligation of one party to make a one-time payment in connection with the replacement of the IBOR-referencing rate with a qualified rate to offset the change in value” that results from that replacement.

How is a permitted “one-time payment” taken into account in the “substantially equivalent value” test?

The proposed regulations require that, in applying the substantially equivalent value test, the parties “must take into account any one-time payment that is made in connection with the alteration.” This means, among other things, that the value of the debt itself before and after the alteration may not have (or be required to have) substantially equivalent value. It also means that the application of the “historic average rate” test may be somewhat more complex when the alteration includes a one-time payment.

The proposed regulations provide that certain rate replacements and associated alterations are not treated as “modifications” at all. Is it better to rely on the proposed regulations, or rather rely on provisions in the existing regulations concerning whether a modification is “significant”?

In most cases, an issuer will be better off relying on the proposed regulations in connection with a rate replacement than the existing regulations. One reason is that the test for whether a modification is “significant” under the existing debt modification regulations requires that all past and future modifications be considered cumulatively. The approach of the proposed regulations has the advantage of not requiring consideration of any other changes that may have been, or may be, made. Also, relying primarily on the proposed regulations may provide more flexibility to make additional changes without resulting in a tax reissuance that are not permitted by the proposed regulations.

How do the proposed regulations affect the special IRS rules that permit conversion of “qualified tender bonds” without tax reissuance?

The proposed regulations contain no express provisions or discussion regarding how they relate to the special favorable IRS rules that permit conversion of the interest rate of “qualified tender bonds” without tax reissuance. In general, however, the proposed regulations in effect should permit more flexibility to convert qualified tender bonds including a LIBOR-referencing rate to another variable rate (for example, by converting to a new replacement rate that was not provided in the bonds on the date of issuance).   

How is a permitted “one-time payment” paid to a holder treated for tax-exempt bond purposes?  

It appears that a one-time payment generally will be treated as tax-exempt interest by an existing holder in many cases.

How is a permitted “one-time payment” paid to an issuer treated for purposes of tax-exempt bond requirements?

The proposed regulations do not expressly address this point, which possibly may be addressed in final regulations. Certain existing authority points to the view that such a one-time payment may need to be treated as proceeds for arbitrage purposes, but not as proceeds for purposes of any of the other tax-exempt bond requirements. The answer to this question may also possibly depend on the type of tax-exempt bond involved.