Transition from LIBOR to alternative reference rates – Guidance on tax issues

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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.

Deemed taxable exchanges upon significant modifications

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:

  • A deemed exchange of a debt instrument could result in the debt holders having capital or ordinary gain or loss, while debt issuers may have corresponding ordinary interest expense (i.e., “repurchase premium”) or ordinary income (i.e., “cancellation of debt income”).
  • If a hedged debt obligation is significantly modified due to a change in LIBOR, then its deemed termination may cause a corresponding gain or loss with respect to the hedge itself. Similarly, changes to a reference rate used in an integrated hedge may cause the debt obligation and derivative to be separated and prevent the taxpayer from re-establishing the integrated hedge treatment for 30 days.
  • Structured financing often involves special purpose vehicles (“SPV”) that are not subject to entity-level income taxes. A transition from LIBOR that causes a deemed exchange of either the debt instruments an SPV holds or the debt instruments a SPV issues to investors can potentially impact the tax status of the SPV. For example, a REMIC is generally not allowed to acquire new loans outside of its initial period; a deemed exchange resulting from a transition from LIBOR could be considered an acquisition of a “new” loan and adversely impact the REMIC and its investors (e.g., if the loan is no longer considered qualified under the REMIC rules, any net income from the loan may be subject to a 100-percent “prohibited transactions” tax).
  • A financial instrument that is otherwise grandfathered out of withholding under FATCA may potentially lose that status if a significant modification occurs.
  • A deemed exchange of a tax-exempt instrument would require that the “new” debt instrument be re-tested for tax-exempt status.
Credit spread adjustments and one-time payments

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:

  • Testing debt instruments for significant modifications under Treas. Reg. Sec. 1.1001-3, as discussed above, can be complicated by the mechanics used for determining the spread adjustment.
  • Timing and character of one-time payments, assuming they are not part of a deemed taxable exchange, are not entirely clear and could differ between counterparties.
  • One-time payments to non-US persons could be subject to withholding rules different from those applicable to the relevant instrument.
  • One-time payments on tax-exempt debt instruments could result in tax if the payments are treated as something other than adjustments of interest on the debt instrument.
Method of accounting changes for dealers in securities

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:

  • Generally, when a taxpayer has established a method of accounting, the taxpayer is required to obtain consent from the IRS to change such method. The IRC section 446 Regulations provide that a change in an overall plan of valuing items in inventory is a change in method of accounting, and likewise a change in the treatment of any material item used in the overall plan for valuing items in inventory is also a method of accounting change. Nonetheless, a change in treatment resulting from a change in underlying facts is generally not an accounting method change.
  • Commenters have expressed uncertainty as to whether a change in discount rates due to replacing LIBOR could constitute an accounting method change. For example, questions may arise as to whether the change in treatment is in regard to a “material item,” or if such change could be considered to have occurred as a result of a “change in underlying facts.”
  • If a change from a LIBOR-based discount cash flow model to an alternative reference rate-based model is considered an accounting method change, securities dealers may face additional administrative burdens including filing for an accounting method change and acquiring consent from the Commissioner.
Transfer pricing

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:

  • MNEs should consider amending existing intercompany loan agreements that reference LIBOR to include fallback language with the agreed actions and timeline by the parties to adjust the pricing in order to determine the equivalent interest rate based on the new alternative base rates available.
  • The transition to an alternative base rate may create comparability differences with the benchmarks applied to price intercompany financing arrangements. MNEs therefore will need to reassess their transfer pricing policies to evaluate consistency with—and produce—arm’s-length results.
  • Treasury groups and in-house banks that enter into hedging contracts to mitigate foreign currency risk should plan for the discontinuance of LIBOR and the resulting impact on their existing intercompany funding and hedging structures. This needs to be considered in light of the entity characterization and expected profits in those entities.
  • For many, the aforementioned change in transfer pricing policies required once LIBOR is replaced will impact the systems and even manual processes for calculating intercompany interest rates. This process will require coordination among various functions including treasury, tax, transfer pricing, legal, finance and technology. It is important to start assessing and developing a plan that will allow for an orderly and timely transition.

Takeaways

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

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