The U.S. tax authorities have issued substantial guidance related to the phase-out of LIBOR – relevant to lenders, borrowers and parties to financial instruments of virtually every type.
In proposed regulations (“the Proposed Regulations”) released on October 9, 2019, the Internal Revenue Service (“IRS”) and the U.S. Department of the Treasury (the “Treasury”) addressed market concerns regarding the U.S. tax effect of the expected transition from LIBOR and other interbank offered rates (“IBORs”) on debt instruments (e.g., loans, notes and bonds) and non-debt contracts (e.g., swaps and other derivatives). The key tax concern to date has been whether the replacement of an IBOR-reference rate in a debt instrument or non-debt contract with a different reference rate would result in a taxable exchange of the debt instrument or contract, potentially triggering a current U.S. tax liability to one or more of the parties.
The core of the Proposed Regulations provide some comfort – they detail the requirements for the rate replacement to not result in a taxable event (either in respect of the instrument itself or to certain integrated hedging transactions). The Proposed Regulations also contain transition guidance on other matters potentially impacted by the rate change, such as maintenance of REMIC status and the calculation of interest expense of a foreign bank with a U.S. branch.
While the Proposed Regulations are broadly taxpayer favorable – and indeed draw heavily on input from the Alternative Reference Rates Committee (“ARRC”), which was charged with facilitating voluntary acceptance of alternative reference rates, as well as comments from other industry groups – their scope is limited enough that affected taxpayers should take care to ensure that amendments to their loans and other financial instruments are tailored to conform to the Proposed Regulations. In particular, in order to avoid a taxable event, affected taxpayers substituting an IBOR-referencing rate for a new rate, such as SOFR, will need to satisfy several tests, including a test of whether the fair market value of the affected loan or financial instrument is substantially equivalent both before and after the rate is changed, taking into account any lump-sum payment made.
Taxpayers may generally rely on the Proposed Regulations until final regulations are published, provided that the rules are applied consistently by taxpayers and their related parties. Read the rest of this post for background on the LIBOR transition, and a more complete description of the Proposed Regulations. Please contact any of the authors listed above or your usual Proskauer contact to discuss any aspect of the Proposed Regulations applicable to your specific circumstances.