In July 2017, the UK Financial Conduct Authority announced that it would no longer compel panel banks to participate in the LIBOR submission process after the end of 2021. As a result of this announcement, market participants have begun the process of preparing for the transition from LIBOR to alternative reference rates.
The Secured Overnight Financing Rate (SOFR) is expected to be the preferred alternative reference rate for US dollar financial products after the transition from LIBOR. However, there are currently a wide range of debt instruments and other financial products that reference LIBOR. Thus, although LIBOR may be available until the end of 2021, market participants have begun planning for the transition. Modifications of both contractual fallback provisions as well as actual rates referenced in existing debt instruments and other financial products are expected in many cases.
Unless specific relief is provided by the IRS, these modifications may cause unintended US federal income tax consequences for issuers and investors of these products, particularly if the modifications are considered significant for tax purposes. Consequently, commenters have requested guidance from the IRS regarding tax issues resulting from a transition from LIBOR. In a letter dated April 8, 2019 to the IRS, the Alternative Reference Rates Committee (ARRC) requested guidance providing that a contractual modification of a financial instrument from referencing LIBOR to an alternative reference rate will not be a taxable event, and that such guidance should be broad and flexible. In an earlier letter dated March 28, 2019 to the IRS, the Structured Finance Industry Group (SFIG) requested similar relief that focused on the effects that a taxable LIBOR transition could have on structured financing.
This insight highlights potential tax issues to be considered based on current law. An upcoming insight will examine the proposal submitted by ARRC dated June 6, 2019, which was stylized by ARRC in the form of a traditional Treasury Regulation.
New financial instruments that reference LIBOR should contain fallback provisions that specify an alternative rate in the event LIBOR becomes unavailable. In such cases, the move to a substitute reference rate generally would not result in a taxable event (because it is occurring pursuant to the terms of an existing contract). For existing instruments with scheduled maturities beyond 2021 that provide for LIBOR-based payments, it is widely anticipated that these contracts will be modified or settled early in conjunction with a replacement contract. In either case, the counterparties should carefully consider whether the new terms could result in tax consequences.
Under regulations issued under IRC section 1001, gain or loss is realized upon the exchange of property differing materially in kind or extent. Specifically, for debt instruments, Treas. Reg. Sec. 1.1001-3 provides rules intended to measure whether modifications are economically significant, which in turn, would result in deemed debt-for-debt exchanges. For non-debt instruments, similar concepts apply under the fundamental change doctrine.
Why this matters:
Modifications of fallback provisions and reference rates within financial product contracts are expected to mitigate market value transfer at the time of transition from LIBOR to a successor rate. Since SOFR is a secured overnight rate, it is expected to be lower than the LIBOR rate it replaces. One way to facilitate an amendment of a financial product to a lower reference rate is through credit spread adjustments. However, one-time payments in addition to or in lieu of credit spread adjustments may also be used to mitigate value transfer.
Why this matters:
Commenters have also requested guidance for securities dealers regarding potential method of accounting changes that may occur as a result of the transition from LIBOR. Specifically, loans held by “dealers in securities” are generally subject to mark-to-market treatment under IRC section 475, which requires the taxpayer to realize gain or loss based on changes in the loan’s fair market value. If market prices are not readily available for the loan, many taxpayers use a discounted cash flow model based on LIBOR to value the debt instrument.
A taxpayer that has used a LIBOR-based discounted cash flow model to value loans for IRC section 475 purposes in prior years will likely need to apply a different discount method after 2021 when LIBOR is no longer available (or earlier and if there are reliability concerns).
Why this matters:
Many multinational enterprises (MNEs) that have intercompany financing structures—e.g., discrete loans, in-house banks, cash pools, factoring arrangements and back-to-back lending arrangements between related parties—price these related-party transactions based on LIBOR. In addition, MNEs with in-house banks often enter into hedging contracts to mitigate foreign currency risk on behalf of other affiliates or as part of managing the risk they bear as part of their funding functions. These hedging contracts are often tied to LIBOR.
Why this matters:
In addition to navigating the technical tax implications of financial product modifications, and irrespective of potential IRS relief, institutions across all industries will need to evaluate the adequacy of their policies, technology systems and operational processes in light of the transition from LIBOR to an alternative reference rate. Additionally, since contracts with stated maturities beyond 2021 will likely require modifications to address the expected discontinuance of LIBOR, institutions could use this market event as an opportunity to assess the overall tax impact of its LIBOR-linked financial products and make additional changes to the contracts and/or policies to optimize overall tax efficiencies beyond just the LIBOR impact.
PwC US contributing authors: Mac Calva, Zach Noteman and Jeff Dahlgren
PwC’s established global network of specialists deeply understands key LIBOR-impacted businesses. We work with you to provide support across the entire lifecycle of the transition - beginning with mobilization and governance, impact assessment, definition of remediation work streams, contract management and remediation, client outreach, systems and process changes, risk and valuation model changes, and managing related tax and accounting implications.
Principal, PwC US
Tax Partner, Structured Products and Real Estate, PwC US
Director, Financial Markets, PwC US