IRS issues new IBOR rate conversion guidance for debt instruments
ComplianceOctober 13, 2020

IRS issues new IBOR rate conversion guidance for debt instruments, swaps and similar financial instruments: Rev. Proc. 2020-44

By: Stevie D. ConlonRobert Schwaba

On Friday, October 9, the IRS released a revenue procedure, Rev. Proc. 2020-44 (“Procedure”). The Procedure provides guidance on modifications of financial instruments necessitated by the move from the London Interbank Offered Rate (LIBOR), and other interbank offered rates (IBORs), to alternative reference rates for use in contracts recommended by the Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA). This includes fallback provisions that provide for the substitution of alternative reference rates for LIBOR and IBOR to assist contract parties in the move away from reference rates destined for obsolescence.

As noted in the Procedure, in 2017 the U.K. regulator and LIBOR overseer, Financial Conduct Authority, announced that LIBOR and its variants, including USD LIBOR, may be phased out after 2021. The Procedure states that the Financial Stability Board and the Financial Stability Oversight Council have warned that “probable elimination of USD LIBOR has created risks that pose a potential threat not only to the safety and soundness of individual financial institutions but also to financial stability generally.”

Previous IRS guidance on the elimination of contract terms referencing LIBOR and other IBORs was found in proposed regulations released in October 2019. For a discussion of these proposed regulations and related OID and other debt calculation issues, see Conlon, Vayser and Schwaba, New IRS IBOR/SOFR rules do not fully resolve calculation challenges for debt, Journal of Taxation of Financial Products, Vol 16, No. 4 (Jan. 21, 2020). In response to comments on the proposed regulations by the ARRC and ISDA, the IRS released the Procedure in advance of the effectiveness of the proposed regulations, to specifically address the ARRC and ISDA fallback language issued by those groups. To support the move to the new reference rate, Secured Overnight Financing Rate (SOFR), the Procedure states that ARRC and ISDA modification language specified in the Procedure will not constitute an exchange of property for materially different property for purposes of IRS Code Sec. 1001 and Treas. Reg. 1.1001-1(a). This avoids the unwanted result of a taxable exchange being triggered by a contract amendment to substitute reference rates.

The Procedure applies to contract modifications after October 8, 2020, and before January 1, 2023, but can also be relied on for modifications before October 9, 2020. The Procedure applies to any contract that references an IBOR and is modified in a way described in the Procedure. Contracts include (but are not limited to) derivative contracts, debt instruments, stocks, insurance contracts, and lease agreements. Modifications allowed by the Procedure are contracts that are modified to add an ISDA fallback provision, contracts modified to add an ARRC fallback provision, and contracts modified to add either type of provision with changes to the provision that come under a category or categories specified in the Procedure. Importantly, the Procedure provides that certain other modifications are permissible, including “reasonably necessary” modifications, modifications to omit certain provisions that are unnecessary, or modifications of related definitions and terms. Market participants and counsel may struggle with the precise demarcation between permitted modifications and those that are not.

The Procedure also provides that the specified modifications “will not be treated as a legging out of an integrated transaction, a termination of a qualified hedge, or as a disposition or termination of either leg of a hedging transaction.”

The Procedure does not address one-time payments related to contract modifications. Such payments were addressed in the IRS proposed regulations, which pointed out that different possible reasons for such payments, might include both compensation for the economic effect of the modification, and payment as an inducement to enter into the modification. Note that another complication resulting from one-time payments is an additional possible reason for the payment, the inducement to enter into modifications of the contract that are not IBOR-related. As a result, separating reference rate modification payments from other contract modifications that would be separately subject to requirements under Treas. Reg. 1.1001-3 may prove difficult. The Procedure also does not address several adjustment issues of significance to holders, including premium, discount and other adjustments that arise due to secondary market pricing differences.

Conclusion

The Procedure provides favorable guidance that addresses concerns raised by industry participants and commenters. However, as noted above, additional issues remain outstanding.

Contact: Robert Schwaba (847) 267-2026