The IRS issued final regulations (TD 9961) that provide guidance on the tax consequences of the transition away from the use of certain interbank offered rates in debt instruments, such as the London Interbank Offered Rate or LIBOR. The final regulations are necessary to address the possibility that a modification to the interest rate terms of a debt instrument or contract to replace LIBOR with a new reference rate could result in a taxable event. Without these final regulations such a change could result in the realization of income, deduction, gain, or loss for Federal income tax purposes.
The final regulations are effective beginning March 7, 2022, and generally follow the guidance issued October 9, 2019, with the proposed regulations.
Background. On July 27, 2017, the Financial Conduct Authority, the United Kingdom regulator tasked with overseeing the London Interbank Offered Rate (“LIBOR”), announced that publication of all currency and term variants of LIBOR, including U.S.-dollar LIBOR (“USD LIBOR”), may cease after the end of 2021. The administrator of LIBOR, the ICE Benchmark Administration, announced on March 5, 2021, that publication of overnight, one-month, three-month, six-month, and 12-month USD LIBOR will cease immediately following the LIBOR publication on June 30, 2023, and that publication of all other currency and tenor variants of LIBOR will cease immediately following the LIBOR publication on December 31, 2021. However, the Financial Conduct Authority has indicated that it may require the ICE Benchmark Administration to publish one-month, three-month, and six-month USD LIBOR after June 30, 2023, using a synthetic methodology. This synthetic USD LIBOR may be published for a limited period of time.
As a result of the expected termination of LIBOR, taxpayers have been working with lenders and others to change the interest rate terms in debt instruments and contracts to move away from a reference to LIBOR. Generally, when taxpayers make a significant modification to a debt instrument a gain or loss may be realized as if the original instrument is exchanged for the modified instrument. Such a modification may also have consequences under the rules for integrated transactions, hedging transactions, withholding, fast-pay stock, investment trusts, original issue discount, and real estate mortgage investment conduits (REMICs).
The final Regulations are intended to provide special rules to help taxpayers adjust to the discontinuation of certain widely used interest rate benchmarks, minimize potential market disruption, and facilitate an orderly transition to new reference interest rates. In connection with the discontinuation of LIBOR, proposed Regulations and now final Regulations generally provide that modifying a debt instrument, derivative, or other contract in anticipation of an elimination of LIBOR is not treated as an exchange of property for other property and gain or loss may not be recognized. The Regulations also adjust other tax rules to minimize the collateral consequences of the transition away from LIBOR.
Nonrecognition of gain or loss applies to “covered transactions” identified by four elements:
- A contract with an operative rate or fallback provision that references a discontinued IBOR (“old reference rate”);
- A modification of that contract (a) to replace the old reference rates with qualified rates and, (b) if the parties so choose, to add an obligation for one party to make a qualified one-time payment;
- Related contract modifications reasonably necessary to adopt or implement the change in rates; and,
- The transaction meets certain rules in Regulation Section 1.1001-6(j) which exclude certain modifications from the definition of covered modification.
The Regulations provide definitions and scope limitations to narrow the transactions that qualify for nontaxable treatment. Businesses modifying debt instruments or other contracts to move away from terms referencing LIBOR, can contact their Cherry Bekaert advisor for guidance.
