A momentous transition for the world’s financial markets is scheduled to take place in the next few years. The London Interbank Offered Rate (LIBOR), a reference interest rate for a variety of financial contracts around the world (e.g., loans, derivatives, mortgages) worth trillions of dollars, is not guaranteed to be published after 2021. LIBOR is designed to represent the average composite rate of interest at which certain leading international banks could borrow from one another on an unsecured basis and is quoted for a number of maturities and currencies. It is calculated based upon submissions from a panel of selected banks. However, the volume of actual transactions (as opposed to theoretical judgments of what rate a bank could borrow funds at if it were to do so) has fallen significantly in recent years, calling into question whether LIBOR is genuinely representative of true market conditions. In addition, even assuming a robust interbank lending market, LIBOR quotes are determined through surveys of money-center banks rather than data on actual transactions among them. Finally, in recent years, serious questions have been raised concerning the governance processes underlying LIBOR.
With the looming end of LIBOR, or at least its relevance as a representative rate, financial regulators around the world, such as the UK’s Financial Conduct Authority (FCA) and the Federal Reserve in the U.S., have been involved in rallying financial market participants to prepare for the transition. In the U.S., the Federal Reserve established the Alternative Reference Rates Committee (ARRC) in 2014 in order to consider criteria for new reference interest rates to replace U.S. Dollar (USD)-denominated LIBOR, as well as related implementation issues (e.g., the facilitation of adoption of alternatives and preparation of recommended contract language). The ARRC originally included representatives from 15 large global interest-rate derivatives dealers. Eventually, several market participants and interested organizations were invited to join as non-voting members.
This article discusses transfer pricing and other U.S. tax implications of the move away from LIBOR, as well as steps that taxpayers should take starting now in order to be prepared for the change. Our focus will be on intercompany financial instruments, particularly debt; many of the issues discussed also apply to third-party arrangements.
POTENTIAL FOR SIGNIFICANT MODIFICATIONS FOR U.S. TAX PURPOSES
Under the guidance of Treasury Regulations Section 1.1001-3, relevant aspects of which are described below, a significant modification of an investment is generally treated for tax purposes as a taxable exchange of the investment for a new investment.
In the debt context, a significant modification generally occurs if (1) the modification does not occur by operation of the terms of the instrument and (2) the modification changes the instrument’s yield by more than the greater of (x) 0.25% and (y) 5% of the unmodified yield. Under a “snapshot” rule, the yield on most instruments that reference LIBOR generally would be their yield on the modification date.
An alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument is not a modification. Such an alteration may occur “automatically (for example, an annual resetting of the interest rate based on the value of an index or a specified increase in the interest rate if the value of the collateral declines from a stated level) or may occur as a result of the exercise of an option provided to an issuer or a holder to change a term of a debt instrument.”
Importantly, any such option must be unilateral in order to not be a modification. Any change to an obligation that requires the consent of both parties, such as under the amendment approach to LIBOR transition described above for new or existing intercompany loan agreements, would customarily have been viewed as at least a modification for U.S. tax purposes and, depending on the magnitude of the resulting change in yield, possibly a significant one, barring any regulatory relief.
Consequences of a Significant Modification
A significant modification of a debt instrument or similar investment can lead to important and potentially unfavorable tax consequences, including:
- Tax recognition for all contracts, including debt and “bullet swaps.” An amendment to an investment’s reference rate could require a holder to recognize a taxable gain earlier than anticipated and to be taxed at short-term capital gains rates. Moreover, the deemed-reissued investment might be subject to special tax-reporting rules that are applicable to “off-market” issuances, such as the original issue discount or bond-premium rules. Finally, a deemed exchange of tax-exempt bonds could require a retesting of the deemed-reissued bonds to determine whether they remain tax-exempt.
- Re-characterization of debt as equity. Under the Section 385 regulations, which re-characterize debt as equity in conjunction with certain transactions, significantly modified debt may lose its “grandfathered” protected status, and therefore be subject to re-characterization as equity. It is also worth noting that, for a number of reasons, a “new” instrument may not enjoy the same degree of interest deductibility as its predecessor/unmodified version. In addition, hedges of the unmodified debt may need to be terminated and new hedges entered into that mirror the new terms of the loan. Termination of the existing hedges may result in the recognition of gain or loss.
- Withholding on U.S. debt instruments. Under tax code Sections 1471-1474, (commonly referred to as the Foreign Account Tax Compliance Act, or “FATCA”), U.S. debt instruments (and any other instruments that give rise to U.S.-source income) that were “issued” on or after July 1, 2014, and that are held by a non-U.S. person may be subject to withholding if the non-U.S. person is a foreign financial institution that fails to certify as to its compliance with certain information reporting requirements, or is a non-financial foreign entity that fails to provide certain certifications regarding its substantial U.S. owners. A significant modification may be treated as a new issuance for this purpose. Thus, taxpayers may be required to build withholding and reporting systems with respect to long-dated debt instruments and potentially other instruments that, absent a reference- rate amendment, might otherwise have been grandfathered out of FATCA.
- COD income for debtors; gain for creditors. A significant modification of debt is treated as a retirement and reissuance of that debt. If the debt has a face amount of more than $100 million and one or more broker-dealer quotes are available for the debt, then the price at which it is deemed to have been retired generally is its fair market value at the time of the significant modification. Under certain circumstances, a debtor is required to recognize cancellation of debt (COD) income if it retires its own debt for an amount that is less than the debt’s principal amount. Accordingly, if, at the time of a reference rate amendment, a debt instrument trades at less than its principal amount, the debtor may have COD income. Conversely, if a debt instrument trades at more than its principal amount at the time of the amendment, then the creditor may have taxable gain.
These examples provide a general overview of the potential consequences of a significant modification. Tax treatment of issuers and holders can differ in some aspects (although a significant modification is the starting point for both).
Given these and other potential adverse consequences of LIBOR replacement, the proposed regulations issued on Oct. 8 provide some welcome relief to affected taxpayers, while raising a few fresh challenges.
New IRS Guidance on LIBOR Transition
The proposed regulation largely eliminate the risk of a modification under Section 1.1001-3 stemming from replacing LIBOR (or an analogous reference rate for non-U.S. dollar loans) with a new reference rate. The new benchmark must meet the definition of a “qualified rate,” which generally includes any rate endorsed or recommended by a central bank or similar authority for this purpose, as long as the currencies of the original and replacement benchmarks are matched. SOFR meets these criteria for U.S. dollar instruments.
One additional criterion for a qualified rate is that the fair market value of the financial instrument post-modification must be “substantially equivalent” to its fair market value prior to the modification. Fair market value may be determined by any reasonable valuation methodology, as long as it is consistently applied. Further, the proposed regulations allow for one-time payments between the parties in connection with a modification (e.g., to equate pre- and post-modification fair market value). Other changes, such as to the timing and frequency of interest payments, may also be allowed if they are associated with the replacement of LIBOR by a qualified rate, and are “reasonably necessary” for that purpose.
The proposed regulations include safe harbor alternatives to the fair market value requirement. For related-party instruments, a replacement rate is qualified if, on the date of modification, the historic average of the LIBOR-based rate does not differ from that of the replacement rate by more than 25 basis points (taking into account any one-time payments). Some specific criteria for measuring historic averages, including relevant time periods, are provided. This safe harbor provision generally converts what might have been an approach to determining the spread adjustment needed for a replacement rate to a means of avoiding the fair market value calculations.
A safe harbor rule is also available for financial instruments contracted between unrelated parties, and is satisfied assuming arm’s-length negotiations on the new rate between those parties.
The proposed regulations, therefore, provide a useful path for avoiding a deemed exchange of an existing financial instrument for a new one, along with potential consequences such as those summarized in the previous section. That path is not without possible bumps, however.
Implications for LIBOR Transition Strategies
Pricing new intercompany contracts against alternate benchmarks such as SOFR would avoid any need to alter the terms when LIBOR rates are no longer published. Similarly, including hardwired language in a new U.S. dollar LIBOR intercompany agreement would not lead to a significant modification under Section 1.1001-3 since the change to a new benchmark would occur according to the original terms of the agreement. An amendment approach could introduce some complications, however, as could the addition of any fallback language to an existing contract.
For a loan, the fair market value can generally be defined as the present value of expected future interest and principal payments, discounted at a risk-adjusted rate. In the LIBOR replacement context, that means that the present values under the previous and replacement rates must be substantially the same. Calculation of present value using a replacement rate such as SOFR requires a robust term structure for the rate, fed by market expectations of forward rates. However, SOFR is currently an overnight rate with no term structure. While it is possible to use average or compounded daily SOFR rates to approximate a term structure for SOFR (the New York Fed is preparing to produce such a backward-looking compounded average alongside the daily SOFR), or to generate forward-looking term SOFR from transaction prices for newly-traded SOFR futures contracts, such approaches may lead to unreliable estimates of fair market value until liquidity in SOFR-linked markets reaches a critical mass. Taxpayers attempting to apply the fair market value criterion of the new proposed regulations might, therefore, need to address some computational challenges, as well as the potential for uneven results over time if the initial approach is applied consistently, as the proposed regulations stipulate.
The magnitude of these challenges may depend on the approach taken when adding fallback language to contracts. While a hardwired approach for a new contract will likely eliminate the risk of a significant modification under Section 1.1001-3, a taxpayer may be more likely to have to contend with the data issues described above when implementing an immediate alteration. An amendment approach allows the transition (including the determination of the spread adjustment and application of the fair market value test) to be executed at a future date with more complete market information; the tradeoff is current uncertainty as to cash flow impact over the life of the instrument. That uncertainty is exacerbated by the potential for continuing volatility in the SOFR market, even if one plans to apply the safe harbor provision for related-party instruments.
If hardwired replacement rates or spread adjustments are currently unavailable or unreliable, taxpayers may opt for a ‘streamlined amendment’ approach for LIBOR transition, wherein the trigger events and many terms for the transition are specified in advance, but the replacement reference rate and spread are determined later. There may also be hybrid approaches which combine elements of the hardwired and amendment strategies, though those may raise the possibility of having to test the new rate twice—up front when the replacement rate is first designated, then again if the parties have some discretion to adjust it.
It is clear that taxpayers holding or issuing U.S. dollar instruments will need to carefully assess their options, including the method and timing of alterations to new and existing contracts, relative to their particular facts and circumstances.
In addition, the proposed regulations distinguish between “associated alterations and modifications” which may be necessary to implement a transition from LIBOR to a new reference rate, such as making a one-time payment or changing the definition of the interest period, and modifications that may be made contemporaneously with LIBOR replacement but are not necessary to the transition. The latter may include adjusting the spread to account for changes to the creditworthiness of the borrower since a loan was first issued, for example, and may result in a significant modification of the instrument for tax purposes (relative to a starting point which includes a proper transition to the new reference rate).
However, practically distinguishing between associated and other contemporaneous modifications may not always be a straightforward exercise. For example, if the new reference rate entails an allowable change to the frequency of interest payments, the new spread will have to be adjusted to account for that change, and one can envision disputes arising as to the distinction between a spread adjustment legitimately associated with the transition to the new rate and what might be deemed to be an unnecessary additional adjustment. The risk of such disputes might be exacerbated by possible disagreements surrounding acceptable calculations for fair market value, including if a range of values is applied rather than point estimates (perhaps more likely given the data limitations described earlier). Further ambiguity may arise around the characterization of necessary associated modifications, e.g., can taxpayers change the tenor of an instrument if they concurrently adjust the spread to equate fair market values?
With respect to any one-time payments made in conjunction with a modification, important questions of characterization of such payments will hopefully be addressed in the final regulations.
SYSTEMS, PROCESSES, AND OTHER CHALLENGES
No matter which approach is adopted for the LIBOR transition, taxpayers will need to address some potential obstacles as they implement a switch out of LIBOR for affected loans. These challenges range from a need to adapt and monitor relevant systems to dealing with possible regulatory scrutiny.
Operational transfer pricing processes and systems manage the implementation of transfer pricing policies, i.e., the design of procedures and enabling technologies to efficiently and accurately execute the necessary intercompany payments day-to-day. This is a key focus area for many multinationals, who at times struggle to correctly apply their stated policies, particularly as the volume of required intercompany flows grows. Tax authorities are increasingly examining not just transfer pricing policies, but also corresponding operational issues. Mistakes in applying stated policies, say due to overly manual intercompany processes, can lead to large tax adjustments even if the policies themselves are accepted. Many multinationals must also contend with non-tax regulators who in recent years have taken more of an interest in accurate, consistent, and timely charging and reporting of arm’s-length payments among affiliated entities.
These operational challenges may be aggravated by the data issues associated with SOFR (and, to varying degrees, other (i.e., non-dollar) replacement rates). LIBOR is quoted at various tenors, ranging from overnight to one year, and a similar structure for SOFR will eventually be needed, both for testing fair market value equivalence under the proposed regulations and, more practically, to price instruments with different interest-reset periods.
Preparing for the LIBOR transition will be a multi-stage process for many companies. A helpful first step would be to take an inventory of existing intercompany loans, organized by the categories discussed in Part I, in order to determine the magnitude of the risk raised by the transition. From that list, companies can assess which intercompany loans might require immediate attention, e.g., in terms of fallback language, and formulate a process to manage the change which applies the tenets of the proposed regulations to minimize the risk of a significant modification. Technology tools can be most helpful in this process.
It behooves taxpayers to design a detailed plan for the LIBOR transition as soon as practical. This should include establishing clear responsibilities and lines of communication among the relevant stakeholders in the organization, such as the tax, accounting, finance, treasury, and legal teams. Each will play a crucial role in designing and implementing the plan, or at the least should agree to it and have the opportunity to raise any issues. The goal is to settle on procedures for the transition, prepare relevant accounting and other systems to adapt to the change, and establish go-forward monitoring procedures.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
About the Authors: Sherif Assef (email@example.com) is a principal in the Economic and Valuation Services group of the Washington National Tax practice of KPMG LLP, based in New York City; Yosef Lugashi is a senior manager in the Economic and Valuation Services practice of KPMG LLP, also based in New York City; Petia Petrova (firstname.lastname@example.org) is a senior manager in the Economic and Valuation Services practice of KPMG LLP, based in Boston; and Jeff Nagle is a partner at Cadwalader, Wickersham &Taft LLP, based in Charlotte.
The authors thank Jason Schwartz and Gary Silverstein of Cadwalader,Wickersham & Taft LLP,and Kathleen Dale, Jonathan Zelnik, Bob Clair, and Oommen Thomas of KPMG LLP for their contributions.
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