Proposed Regs Allow Tax-Free Replacements of LIBOR-Based Interest Rates

Proposed regulations allow taxpayers to make tax-free replacements of interest rates tied to LIBOR (London Interbank Offered Rate) in debt instruments and non-debt contracts. Taxpayers may rely on the proposed regs until they are finalized. LIBOR is likely to sunset at the end of 2021.

Why Replace LIBOR?

LIBOR rates are based on the average interest rate that major banks pay on short-term loans to each other. LIBOR has been used as a reference for interest rates for more than 30 years, and is currently incorporated into more than $350 trillion in loans, mortgages, derivatives and other debt.

However, LIBOR actually measured few real transactions. Instead, a bank could report the interest rate it thought it would pay if it borrowed funds from another bank. Not surprisingly, some banks manipulated these rates to artificially raise or lower LIBOR.

LIBOR Damaged by Scandal, Declining Use

By 2012, the banks’ manipulation of LIBOR was a full-fledged scandal. At the same time, the data that LIBOR was based on was drying up, as banks used fewer and fewer unsecured interbank loans.

After several efforts to reform and strengthen LIBOR, the U.K. Financial Conduct Authority announced in 2017 that all variants of LIBOR, including U.S.-dollar LIBOR (USD LIBOR), could be phased out by the end of 2021. USD LIBOR is used in more than $200 trillion in currently outstanding contracts.

What’s Replacing LIBOR?

In the U.S., the Alternative Reference Rates Committee (ARRC) announced in 2018 that it had selected the Secured Overnight Financing Rate (SOFR) to replace USD LIBOR. Several other countries have announced similar replacements based on SOFR-type rates tied to their own currencies and banking systems.

The ARRC also asked the IRS to provide guidance about tax issues associated with the transition from LIBOR. The IR responded by releasing these proposed regulations.

What’s the Difference Between SOFR and LIBOR?

SOFR is very different from LIBOR. For one thing, SOFR is based on transactions in the Treasury bond repurchase (repo) market of interbank overnight loans. SOFR is an average rate based on each night’s transactions, which is published the next day at around 8 am New York time.

Since these loans are collaterialized by U.S. Treasuries, they are virtually risk-free. In contrast, LIBOR was supposed to take into account credit risks among the banks and, theoretically, in the economy as a whole. The lack of risk in the repo market is expected to make SOFR lower then LIBOR.

In addition, SOFR is based on about $800 billion in daily trading activities, which is around 1,500 times the daily LIBOR transactions. More importantly, SOFR is based on actual lending transactions, rather than interest rates that banks think they would pay. These factors should make SOFR more robust and harder to manipulate.

LIBOR has one big advantage, however. LIBOR provides rates for different loan terms, while SOFR is based on overnight loans only. However, major financial institutions have already started issuing SOFR derivatives, which can be used to develop SOFR-based term rates.

Are There Tax Consequences for Replacing LIBOR?

The proposed regs are intended to allow taxpayers to replace LIBOR in debt instruments and contracts without tax consequences. The regs accomplish this goal by removing such replacements from the category of “significant modifications.” 

A significant modification to a debt instrument or contracts is generally treated as an exchange or termination of the original instrument or contract. Thus, a significant modification generally causes the parties to realize income, deduction, gain or loss. 

What do the Proposed LIBOR Replacement Regs Do?

The proposed LIBOR replacement regs have six major components:

  1. Proposed Reg. §1.1001-6(a) allows a qualified interest rate to replace a LIBOR rate without tax consequences.
  2. Proposed Reg. §1.1001-6(b) provides requirements for a qualified interest rate.
  3. Proposed Reg. §1.1001-6(c) expands these rules to debt instruments and derivatives in integrated transactions and hedges.
  4. Proposed Reg. §1.1001-6(d), (e) and (f) provide rules for one-time payments, grandfathered obligations, and OID and REMICS, respectively.
  5. Proposed Reg. §1.1275-2(m) offers rules for variable rate instruments.
  6. Proposed Reg. §§1.860G-1(e) and 1.882-5(d)(5)(ii)(B) provide special rules for REMICs and banks, respectively.

When is a LIBOR Replacement Tax-Free?

Under the proposed regs, there are no immediate tax consequences when a change to a debt instrument or a non-debt contract:

  • merely replaces or provides a fallback to a qualified LIBOR-referencing rate, but
  • does not change the fair market value of the instrument or contract, or the reference rate currency.

The proposed regs include flexible rules and two safe harbors for determining if the new rate is a qualified rate.

Any other replacement of a LIBOR rate is subject to the general modification rules that generally treat a change in interest rates as a realization event.

The IRS has requested comments on the proposed regs, especially with respect to other complications that may arise from the replacement of LIBOR with a qualified rate.

By Kelley Wolf, JD, LLM

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All stories by: CCHTaxGroup