On December 30, 2021, the Treasury Department and the Internal Revenue Service released Treasury Decision 9961 (REG-118784-18) promulgating final regulations related to the ongoing transition in the financial markets away from interbank-offered reference rates (IBORs) such as the London Interbank Offered Rate (LIBOR). The final rulemaking, which became effective at the beginning of March 2022, is largely captured in new Treasury Regulations Section 1.1001-6, and provides standards for determining whether the modification of the terms of a financial instrument, such as a tax-exempt bond or an interest rate swap contract, to replace references to an IBOR with a new reference rate, either at the time of modification or thereafter, will trigger a “realization event” that could necessitate the recognition of income, or of a deduction or gain or loss item, for federal income tax law purposes.
As applied in the field of tax-exempt finance, these regulations are intended to govern whether bonds with LIBOR-indexed interest rates must be treated as reissued when the parties to the bonds modify their terms to provide for a successor index rate, such as the Secured Overnight Financing Rate (SOFR), or whether the interest rate swap contracts related to those bonds have been materially modified when something comparable is done with respect to the LIBOR benchmarks they reference. On the whole, these rules appear to live up to the advertising of Treasury officials, who assured bond market participants a number of years back that the tax regulators were developing helpful guidance that would provide an assurance, in most (if not all) cases, that modifications of bonds to implement a LIBOR transition would not result in a reissuance of the bonds in question, or that a similar modification of a bond-related interest rate swap would not necessitate a fresh analysis under Treasury Regulations Section 1.148-4(h) and a possibly a re-identification in order to maintain its “qualified hedge” status.
The new regulations follow the promulgation of proposed regulations in October 2019 on the same subject matter (see our October 21, 2019 Client Alert on the proposed regulations), reflecting an adoption of the proposed rules, with certain changes, and offering additional guidance on the inclusion of “fallback” language in a financial instrument that is designed to take effect with respect to an IBOR succession occurring after the date of modification of the instrument. The release of this guidance, which applies to modifications of financial instruments on and after March 7, 2022, is particularly timely as banking regulators have prescribed the cessation of publication of U.S. dollar-denominated overnight, one-month, three-month, six-month and twelve-month rates no later than June 30, 2023.
Overall, the final regulations appear to follow the design of the 2019 proposed regulations, although there are notable changes. For example, the final regulations do away with the contrast in the proposed regulations between debt contracts and non-debt contracts (keep in mind that these rules are intended to address modifications to all sorts of LIBOR-referencing instruments that may affect tax reporting for a U.S. taxpayer, not just tax-exempt debt obligations); the final regulations instead employ a broad “contract” terminology that is meant to cover insurance contracts, corporate stock, leases and other financial arrangements that reference IBORs, in addition to bonds, notes and interest rate derivative contracts.
For tax-exempt bond issuers and borrowers, though, the most significant evolution in the final regulations, compared to the 2019 proposed regulations, is the helpful jettisoning of the requirement for testing fair market value equivalency (comparing the modified financial instrument to the unmodified one) in connection with modifications to effectuate a LIBOR transition. This development should enhance the administrability of these rules, and certifications will not have to be drafted, and due diligence will not be required, specifically to establish the fair market value of financial instruments before and after LIBOR succession modifications are made. The final regulations manage to dispense with fair market value concepts by employing the notion of “covered modifications” to identify LIBOR-related modifications that will not trigger a realization event for federal tax law purposes, and by excluding from the definition of “covered modifications” certain specified changes to financial instruments that are treated as “excluded modifications” that may trigger a realization event under the generally-applicable rules of Treasury Regulations Section 1.1001-3. In doing so, Treasury appears to have taken a “rough justice” approach to approximate the outcomes that would have obtained under the explicit fair market valuation equivalency standards of the 2019 proposed regulations.
Covered Modifications and Associated Modifications
Under the final regulations, a “covered modification” is generally defined as any modification of a financial instrument: (1) to replace a discontinued IBOR with a “qualified rate”; (2) to provide a “qualified rate” as a fallback to a discontinued IBOR; or (3) to replace a discontinued IBOR that serves as a fallback in the instrument with a “qualified rate”. In connection with each of the foregoing, the final regulations contemplate that the parties may make “associated modifications” that are reasonably necessary to adopt or implement a covered modification, including for the making of an “incidental” cash payment by one counterparty to the other to cover “small” differences in the valuation of the modified instrument compared to the instrument’s value prior to modification, without triggering a realization event. These definitional provisions also contemplate that a “covered modification” can be accomplished by the parties to a financial instrument by way of replacement of the entire instrument with a substitute, as long as the effect of the replacement is to make covered modifications (and associated modifications) to the existing arrangement.
The basic definitional parameters as to what will constitute a covered modification seem intuitive enough, and they should be if these regulations are to have any utility to market participants, but there may be doubts at the margins as to what constitutes, or does not constitute, an “associated modification”, which is defined by the final regulations to mean a change to the technical, administrative or operational terms of the financial instrument that are reasonably necessary to adopt or implement an IBOR transition. Many bond counsel will take a “but for” approach to resolve these interpretive questions, and perhaps they will take comfort from the administratively deferential formulation in the regulations, which countenances associated changes that are “reasonably necessary” to effectuate a LIBOR transition in a debt instrument. Some bond counsel may even seek input from financial advisors as to what modifications are reasonably necessary to implement a particular LIBOR succession effectively.
There may be more doubt, however, about what constitutes an “incidental” cash payment. To begin, it seems quite clear that this concept is not intended to permit any true-up payment associated with LIBOR succession to be treated as part of a “covered modification” sequence: unless the payment stems from the modification of purely administrative terms in the contract, the payment probably will not constitute an “associated modification” that can be viewed as going hand-in-hand with a “covered modification”. And, even if the payment stems from such a modification, it will only be treated as part of the “covered modification” plan if it is “small”. Vague as it is, this standard may sometimes be challenging to apply to real-world facts; in some of those cases, the alternative may be to analyze the payment provision separately from the “covered modification” provisions in a LIBOR succession exercise, under the general reissuance principles of Treasury Regulations Section 1.1001-3.
Discontinued IBORs
In another change from the 2019 proposed regulations, the final regulations add the concept of “discontinued IBORs” into the analysis. Generally, an IBOR will be treated as a “discontinued IBOR” when a competent banking regulator announces that the publication of that particular IBOR will be discontinued permanently or indefinitely, and (here’s the catch) an IBOR will no longer be a “discontinued IBOR” one year after the regulator no longer publishes that particular IBOR.
Qualified Rates
Let’s take a look now at the “qualified rate” concept in the final regulations. “Qualified rates” generally will include any “qualified floating rate” within the meaning of Treasury Regulations Section 1.1275-5(b), but without regard to the limitations on multiples set forth in those regulations. Examples of such qualified floating rates are given, including SOFR, the Sterling Overnight Index Average (SONIA), the Tokyo Overnight Average Rate (TONA) and the Swiss Average Rate Overnight (SARON), as well as the euro short-term rate administered by the European Central Bank. The definition of “qualified rate” also includes a rate selected, endorsed or recommended by the Alternative Reference Rates Committee (also known as the ARRC) as a replacement for U.S. dollar-denominated LIBOR, but only if the Federal Reserve Bank of New York is an ex officio member of the ARRC at the time of the selection/endorsement/recommendation. Rates that are determined by adding fixed spreads to the foregoing categories of “qualified rates” also are treated as “qualified rates”. Finally, for our purposes, additional “qualified rates” can be specified by the tax regulators by publication in the Internal Revenue Bulletin.
All of this seems straightforward enough, particularly if the current trend toward SOFR as a durable, long-term replacement for LIBOR reference rates in the tax-exempt bond market continues. If there’s an unforeseen shift in the market to another type of reference rate, to one that is not clearly captured in the substantive standards described above, we can hope that Treasury will be nimble enough to respond quickly with an endorsement of that rate in the Internal Revenue Bulletin.
Fallback Rates
Fallback rates are intended to be implemented as substitutes for IBORs after the modification of a financial instrument, on the happening of specified events, such as the actual cessation of publication of a LIBOR reference rate that is still being published at the time of modification. As noted above, a covered modification will include the specification of a fallback rate that is a qualified rate. The final regulations also recognize that parties to a financial instrument may specify multiple fallback rates at the time of modification, and they provide that as long as each of the specified fallback rates constitutes a qualified rate, a modification of a financial instrument to include those fallbacks will be a covered modification.
Under the final rules, fallbacks must be tested twice—at the time of initial modification of the financial instrument and again at the time the fallback is activated as an operative reference rate. Parties will likely want to include an approving opinion of counsel requirement in connection with the post-modification activation of a fallback rate; this would be consistent with the opinion requirements that have been commonly included in fallback modification provisions that have been drafted for several years.
If, however, a fallback rate is indeterminate at the time of modification, the modification will not be treated as a covered modification, and presumably, the modification will be thrown into the general reissuance rules of Treasury Regulations Section 1.1001-3 for analysis, unless the fallback rate constitutes a remote contingency.
Excluded Modifications
As noted above, the final regulations carve out certain “excluded modifications” from “covered modification” treatment, in order to provide a regulatory framework that, as a whole, is consistent with the now-abandoned fair market value equivalency standard. Under the final rules, excluded modifications are any modifications that alter the amount or timing of cash flows provided in a financial instrument and are intended to (1) induce a counterparty to perform an act necessary to consent to a covered modification; (2) compensate a counterparty for a modification that is not a covered modification; (3) grant a concession to a counterparty because that counterparty is in financial difficulty; (4) secure a concession by a counterparty to account for the credit deterioration of another party to the financial instrument; or (5) compensate a counterparty for a change in rights or obligations that are not derived from the modification of the financial instrument. It is noteworthy that the regulations frame the excluded modification analysis in part on the intention of the parties.
Examples of excluded modifications given in the final regulations include an “inducement spread” scenario, in which the issuer of widely-held LIBOR-indexed bonds offers what appears to be a 10 basis point “sweetener” to the spread on a bond to be modified to provide for a SOFR index, to ensure that bondholders will give required consents to the modification. Although the premise is unstated in the example, it appears that this sweetener is over and above the index spread on the modified SOFR-referencing bonds that would be required to achieve substantial equivalency between the fair market value of the bonds before and after modification. Another example, with what appears to be comparable economics, describes the payment of a “consent fee” to the bondholder to secure the required consents, with the same outcome.
Yet another example describes a situation in which, for reasons unrelated to LIBOR succession, the parties agree to modify customary financial covenants in the debt instrument in a manner that benefits the obligor; in exchange, the obligor agrees to add another 30 basis points to the spread on the modified SOFR-indexed obligation. This too constitutes an excluded modification.
The common thread in these examples seems to be that issuers and borrowers, and their counsel, will want to think critically about each and every LIBOR modification even if it is clear that the intention of the parties is simply to provide a succession after LIBOR reference rates are no longer used or usable in connection with bonds or swaps. There will always be a potential for other, more extraneous factors to weave their way into the modifications, and to the extent that they appear not to be strictly mandated by the goal of replacing a LIBOR-referenced rate in a bond or swap instrument, the final regulations seem to call for an analysis of whether those other modifications should be analyzed separately under the general reissuance principles of Treasury Regulations Section 1.1001-3.
The preceding is only a brief summary of the aspects of the final LIBOR transition regulations that are most likely to affect public finance market participants. Issuers and borrowers of tax-exempt bonds should consult with their counsel and their financial advisors to determine how to apply the concepts and requirements in the final regulations to manage LIBOR succession modifications in their debt portfolios.
Please contact Antonio Martini at (617) 378-4136 or another member of Hinckley Allen’s Public Finance Group if you would like more information about the final LIBOR transition regulations, or if you have any other tax-exempt bond compliance matter you would like to discuss.