On October 8, 2019, the Internal Revenue Service (“IRS”) published proposed regulations (“Proposed Regulations”) relating to the transition from the current use of the London Interbank Offered Rate (“LIBOR”) to other interbank offering rates (“IBORs”) as new reference rates for loans, bonds, and hedges. The Proposed Regulations impact municipal issuers (and conduit borrowers) that have issued variable rate tax-exempt or taxable bonds, (or other debt instruments that utilize LIBOR as a reference rate) or have entered into interest rate hedges (e.g., swaps and caps) with rates tied to LIBOR. Among other things, the Proposed Regulations are generally intended to provide that the substitution of another reference rate for LIBOR in these situations is not a “reissuance” of the related bonds or a deemed “new” interest rate hedge.
In 2017, the U.K. Financial Conduct Authority announced that LIBOR would be phased out after 2021. Since that announcement, there has been a concern that replacing LIBOR with an alternative reference rate could result in tax consequences for issuers of tax-exempt and taxable bonds, including a deemed exchange (i.e., a “reissuance”) of the original debt instrument for a “new” debt instrument, resulting in a tax-event for bondholders and, in the case of tax-exempt bonds, the complexities of a “new” issuance for the bond issuer. Somewhat similar consequences can result under the arbitrage rules applicable to tax-exempt bonds with respect to hedges tied to LIBOR where those hedges have been “integrated” for arbitrage purposes. As further described below, the Proposed Regulations generally provide rules under which these consequences can be avoided.
The most significant aspect of the Proposed Regulations is to clarify the application of the reissuance rules to the transition of existing debt instruments from LIBOR to new reference rates. Treasury Regulations (the “Reissuance Regulations”) provide that an existing debt instrument will be treated as reissued if the terms of the debt instrument are modified in a manner that is considered significant under the regulations.
Under the Proposed Regulations, an alteration of the terms of a debt instrument to replace a rate (or a fallback rate) referencing LIBOR (or another “IBOR”) with a “qualified rate” is not a modification and therefore will not result in a reissuance. The same rule applies to “associated alterations” that are connected with the replacement of the LIBOR rate and reasonably necessary to adopt or implement that replacement.
“Qualified rates” include a list of enumerated rates, including the Secured Overnight Financing Rate (“SOFR”), provided the fair market value of the debt instrument before and after the reference rate replacement is substantially equivalent (“value equivalence”). Fair market value for this purpose can be determined by any reasonable valuation method as long as the method is applied consistently and takes into consideration any spread adjustments as well as any one-time payments made in lieu of spread adjustments.
Importantly, the Proposed Regulations establish two safe-harbors to meet the value equivalence requirement. The first safe harbor is met if, at the time of the alteration, the historic average of LIBOR is within 25 basis points of the historic average of the reference rate that replaces it. Notably, for purposes of meeting this safe-harbor, the new reference rate that replaces the existing IBOR reference rate is inclusive of any payment or spread adjustments. Any reasonable method can be used to compute the historic average provided (i) the lookback period from which historic data is drawn begins no earlier than 10 years prior to the alteration, and (ii) the historic average takes into account every instance of the relevant rate published during the selected lookback period. We note that there may be some uncertainty in the application of this safe harbor in certain contexts including, for example, the fact that SOFR has only been published since 2018.
The second safe harbor is met if the parties to the debt instrument are unrelated, and the parties determine, based on bona fide, arm’s length negotiations, that the fair market value of the altered debt instrument is substantially equivalent to the fair market value of the debt instrument before the alteration. From a practical standpoint, the second safe harbor will apply most frequently to privately placed debt such as bank loans—where the issuer (or conduit borrower) and purchaser negotiate an alternative rate.
As discussed above, fair market value must take into consideration any one-time payment made as part of the index change. In other words, the interest rates determined using the old reference rate and new reference rate can be different so long as any difference in value is accounted for through a one-time payment.
Generally, the alteration of a swap or non-debt instrument may constitute a “tax-event” (i.e., the hedge equivalent to a reissuance). Under the Proposed Regulations, altering a hedge to replace a rate (or fallback rate) referencing LIBOR with a qualified rate is not treated as a deemed exchange of the “old” hedge for a “new” hedge if the value equivalence and other requirements of the Proposed Regulations are met.
In the case of issuers (and conduit borrowers) that have hedges that are integrated with a tax-exempt bond for purposes of determining bond yield under the arbitrage rules, the Proposed Regulations specifically provide that a modification of a contract to replace LIBOR with another qualified rate on a hedge that is integrated as a qualified hedge is not treated as a termination of that qualified hedge provided that the hedge as modified continues to meet the requirements to be a qualified hedge. Importantly, when determining whether the modified hedge is a qualified hedge, the fact that the existing qualified hedge is “off-market” as of the date of the modification is disregarded.
Application of the Proposed Regulations
The Proposed Regulations would apply to alterations or modifications of debt instruments and hedges that occur on or after the date of publication of final regulations adopting the Proposed Regulations. However, bond issuers and other taxpayers are permitted to apply the Proposed Regulations to modifications or alterations of debt instruments and hedges that occur before the date of publication of final regulations provided the taxpayer and its related parties consistently apply the rules before that date.
- The Proposed Regulations are drafted to provide guidance regarding any IBOR being replaced. Although this alert is focused on replacements of LIBOR, the same rules would apply to the replacement of other IBORs.
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