Treasury Releases Proposed LIBOR Replacement Regulations

On October 8, 2019, the United States Department of the Treasury released proposed regulations (the “Proposed Regulations”) specifying how an amendment to a debt instrument or non-debt contract (e.g., a swap) to replace the reference to an interbank offered rate such as LIBOR, or to provide for a fallback rate, will be treated for various U.S. federal income tax purposes. The Proposed Regulations were issued in response to the UK Financial Conduct Authority’s announcement that it would phase out the publication of LIBOR after 2021.

Of particular relevance to issuers of tax-exempt bonds, the Proposed Regulations generally provide that such an amendment will not cause bonds or other debt instruments, and non-debt contracts likes swaps to be “re-issued” for U.S. federal income tax purposes if the replacement rate or replacement fallback rate is a “qualified” rate (as defined in the Proposed Regulations) AND the fair market value of the instrument being amended is not substantially different before and after the amendment, taking into account any one-time payment made to equalize values (the “fair market value test”).

The Proposed Regulations specify several “qualified” rates, which include the Federal Reserve’s “Secured Overnight Financing Rate” (“SOFR”) and any rate determined by reference to SOFR or another “qualified” rate, such as a rate determined by adding basis points to SOFR or by multiplying SOFR by a percentage.

The Proposed Regulations also have two safe harbors for determining whether the fair market value test is met. The first safe harbor is met if the historic average of the prior reference rate does not differ by more than 25 bps from the historic average of the replacement rate, taking into account any one-time payments made in connection with the change. The second safe harbor is met if the unrelated parties to a debt instrument or non-debt contract determine, upon a bona fide arm’s-length negotiation, that the fair market value of the instrument before and after the modification/alteration is substantially equivalent.

Further, the Proposed Regulations provide that an amendment to an interest rate swap that is a “qualified hedge” for a bond issue for purposes of the arbitrage regulations under section 148 of the Internal Revenue Code to specify a “qualified rate” as a replacement for a LIBOR rate in the hedge will generally not be treated as a termination of the hedge for arbitrage purposes if certain requirements are met, including a requirement that the amended swap qualify as a “qualified hedge” under the arbitrage regulations.

The Proposed Regulations also provide that alterations or modifications that are associated with, and necessary to adopt or implement, the replacement rate or provision for a fallback rate are not treated as modifications. For example, a change to the timing and frequency of determining rates or changing the definition of an interest period are not considered modifications. Similarly, the addition of an obligation for a party to make a one-time payment in connection with the replacement of a new interbank offered rate will not be a modification.

Other alterations that occur contemporaneously with the changes described above that are not related to the replacement of an interbank offered rate or providing a fallback rate are, however, tested under the normal re-issuance rules. The new reference to an interbank offered rate will be treated as if it were part of the unaltered instrument. Thus, parties cannot alter a debt for other purposes and avoid a deemed reissuance by changing the referenced interbank offered rate at the same time.

The proposed rules will apply to alterations that occur on or after the publication of the final regulations adopting such rules. Parties may, however, apply the rules in the Proposed Regulations prior to the final adoption so long as the rules are consistently applied by all parties. Note that the Proposed Regulations do not provide for a window of applicability or limit the amount of alterations for a specific debt. Thus, parties to an instrument may apply these rules any number of times going forward in the event that a change to the referenced interbank offered rate is desired or necessary.

The full text of the Proposed Regulations can be found here.

If you have any further questions regarding the impact of the Proposed Regulations, please contact any member of our Public Finance Group.