Recently, the Treasury Department and the Internal Revenue Service released proposed regulations (REG-118784-18) offering guidance related to the anticipated transition in the financial markets away from interbank-offered reference rates (IBORs) such as the London Interbank Offered Rate (LIBOR). The impending “sunset” of LIBOR and similar indicative rates has been and remains a topic of great interest for financial market participants with debt obligations bearing interest based on IBOR-type rates, or with “derivative” instruments such as interest rate swaps that are tied to these rates. The proposed regulations that were released on October 9 appear to be crafted to make the federal tax accounting and compliance issues associated with the sunset and transition to successor interest rates significantly less burdensome than they might otherwise be for these market participants.
Of particular note for purposes of this discussion, the proposed regulations address tax accounting issues for tax-exempt bonds, and for interest rate hedges that are treated as “qualified hedges” with respect to tax-exempt bonds, under the so-called “reissuance” rules of Section 1001 of the Internal Revenue Code of 1986 (the “Code”).[1] We will focus on how the application of the proposed regulations can benefit issuers and borrowers of tax-exempt bonds that are tied to LIBOR.[2]
First, Some Background—Why is LIBOR Sunsetting?
Published each business day, LIBOR rates are intended to provide current cost-of-funds benchmarks based on the interest rate one bank would charge to another in London for loans with durations ranging from overnight to one year, denominated in five currencies—U.S. dollars, British sterling, euros, Japanese yen and Swiss francs. LIBOR-based reference rates came into widespread use in the 1970s and 1980s and today are employed around the world in a vast number of financial transactions, with an aggregate par denomination in the hundreds of trillions of dollars. Despite the widespread adoption of LIBOR in financial markets around the world, however, it has emerged over the last decade that the mechanisms by which LIBOR rates are established are or can be unduly subjective and therefore subject to manipulation. Accordingly, beginning in 2012, banking regulators in the United Kingdom, the United States and in other jurisdictions initiated processes intended to transition from LIBOR to interest rate benchmarks that are more objectively indicative of current costs of borrowing.
In 2017, the Financial Conduct Authority of the United Kingdom announced that regulatory support for all LIBOR benchmarks would be eliminated after 2021. In March 2018, the Alternative Reference Rates Committee (ARRC), which was created by the U.S. Federal Reserve Board and the Federal Reserve Bank of New York to explore possible successors to LIBOR, published a report endorsing the Secured Overnight Financing Rate (SOFR) as the recommended replacement for dollar-based LIBOR indices, and the Federal Reserve Bank of New York began publishing SOFR rates[3] in April 2018. The Bank of England, the European Central Bank, the Bank of Japan and the Swiss Central Bank are currently working on non-dollar denominated LIBOR successors as well. And, while the regulatory landscape of the LIBOR transition is not complete today, financial markets observers have noted that market participants are likely to move away from LIBOR benchmarks on a voluntary basis in substantial numbers prior to the end of 2021.
In anticipation of such moves, the Treasury Department and the IRS announced that they were releasing the proposed regulations to address the possibility that an alteration of a debt instrument or a modification of hedging agreements (and other contracts) to replace a referenced LIBOR rate with a new reference rate could result in the realization of income, deduction, gain or loss for federal tax law purposes or could result in other federal tax law consequences. In doing so, Treasury and IRS signaled a desire to be helpful to market participants, noting their intention to “broadly facilitate the transition away from” LIBOR.
How Would the Proposed Regulations Affect Tax-Exempt Bonds?
The proposed regulations would offer new guidance, under Code Section 1001, in the provisions of federal tax law governing reissuances. Reissuances are “realization events” that generally can trigger the need to account for income, deductions, gains or losses. In the context of tax-exempt financing, bond reissuances can occur when the terms of a bond are materially modified. The reissuance of tax-exempt bonds generally will trigger a need to promptly file an information return on IRS Form 8038, and it may accelerate the timing of payment of an arbitrage rebate liability with respect to the bonds, or require other tax law compliance measures to be taken. Failure to recognize a reissuance event with respect to such bonds, even if inadvertent, may have an adverse effect on their tax-exempt status.
Similarly, a material modification to the terms of an interest rate swap contract that is treated as a “qualified hedge” with respect to a tax-exempt bond issue may be a type of “realization event” that requires a re-identification of the hedge to the bonds in order to maintain its status as “qualified hedge”. If such an event goes unrecognized, it may not be possible to continue to characterize the swap as a “qualified hedge” on the bonds, which may have an adverse effect on the computation of the arbitrage yield on the bonds, and even on the tax-exempt status of the hedged bonds.
The proposed regulations generally provide that, if the terms of a tax-exempt bond are altered, or the terms of a “qualified hedge” are modified to replace, or to provide an alternative to, a LIBOR rate,[4] and the alteration or modification of the bond or hedge does not change the fair market value (FMV) of such bond or hedge, the alteration or modification will not constitute a “realization event” for purposes of the reissuance rules of Code Section 1001.[5] Treasury and IRS have explained that the purpose of this FMV requirement is to ensure that the alterations or modifications to which the special rule in the proposed regulations is applied are generally no broader than necessary to effectuate the LIBOR rate substitution.[6]
What are the Specific LIBOR Transition Rules that Relate to Tax-Exempt Bonds?
The proposed regulations apply to the amendment of tax-exempt bond terms to replace a LIBOR-referencing rate with a so-called “qualified rate”. “Qualified rates” are rates specified in the proposed regulations, such as SOFR, that have been approved by certain sovereign bank regulatory authorities.[7] Treasury and the IRS may specify additional qualified rates in the future by publication in the Internal Revenue Bulletin.
In order to avoid reissuance treatment, the proposed regulations generally require that the FMV of the tax-exempt bond or of the qualified hedge after the substitution of the qualified rate be substantially equivalent to the FMV of the instrument before the substitution. Two safe harbors are provided in the proposed regulations to establish compliance with this FMV equivalency requirement.
Under the first safe harbor, FMV equivalence will be established if at the time of substitution the historic average of the LIBOR-referencing rate is within 25 basis points of the qualified rate that replaces it. For this purpose, the look-back period from which the historic data is derived must begin no earlier than 10 years prior to the substitution and end no earlier than three months prior to the substitution. In addition, for the look-back period that is used, the historic average must take into account every instance of the relevant rate that was published during that period. Within these parameters, however, any reasonable averaging methodology may be used. Alternatively, the proposed regulations provide that the historic average of a rate may be computed in accordance with an “industry-wide” standard, such as the standard set for historical averaging purposes by the ARRC or by the International Swaps and Derivatives Association (ISDA).
Under the second safe harbor, which can be employed separately from the first, FMV equivalence will be established if the bond obligor and the bondholder (or the bond obligor and the swap counterparty, in connection with a qualified hedge) determine, through a bona fide, arm’s length negotiation regarding the substitution of a qualified rate, that the FMV of the altered bond or hedge contract is substantially equivalent to the FMV of the instrument prior to the substitution. In making this determination, the parties must take into account the value of any one-time “true-up” payment made in lieu of an adjustment to the spread that is employed as part of the modified interest rate formula. This direct-negotiation safe harbor is available only if the negotiating parties are not related to one another.
Can We Apply the Proposed Regulations Now? Would that be Beneficial?
The proposed regulations can be relied on until final tax regulations relating to LIBOR substitution are adopted, provided that the rules therein are consistently applied. This means that bond issuers and borrowers can apply the principles in the proposed regulations today with respect to a LIBOR substitution for a tax-exempt bond or qualified hedge. Taking a broad view, the ability to apply them immediately is likely to make this proposed guidance attractive to many bond issuers and borrowers with LIBOR exposures, directly or indirectly, in their debt portfolios, particularly if there is a desire to address and resolve these exposures promptly. This is because many issuers and borrowers will be able to use the proposed guidance as a pathway to ensure that the amendment of bond or interest rate swap terms to provide for a successor rate to LIBOR is a “non-event” for tax accounting purposes, rather than a “recognition event” with the risks noted above that are attendant on reissuances.
The preceding is only a brief summary of the aspects of the proposed 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 whether and how to take advantage of the special rules in the proposed regulations to manage current LIBOR exposures in their debt portfolios.
Please contact Antonio D. Martini at (617) 378-4136 or any other member of Hinckley Allen’s Public Finance Group if you would like more information about the proposed LIBOR transition regulations, or if you have any other tax-exempt bond compliance matter you would like to discuss.
[1] The proposed regulations also address a number of other tax accounting issues under the Code pertaining to the substitution of post-IBOR reference rates in existing debt instruments and non-debt contracts such as interest rate hedges, including the treatment of such instruments and contracts for purposes of the “original issue discount” rules of Code Section 1275 and the treatment of real estate mortgage investment conduits (REMICs) that use IBOR-based interest payment mechanisms. These other aspects of the proposed regulations are not addressed in this publication.
[2] For simplicity, in the balance of this publication, references will be made exclusively to LIBOR, because U.S. dollar-denominated LIBOR reference rates are the predominant form of IBOR used in the public finance markets in the United States. The principles of the proposed regulations described herein, however, have a general application to the transition from all IBOR-based reference rates.
[3] SOFR is based on the U.S. Treasury repurchase (or repo) market, in which U.S. Treasury securities are loaned and borrowed on an overnight basis. SOFR uses data from overnight Treasury repo activity to calculate a rate published on the next business day by the Federal Reserve Bank of New York. The ARRC, in collaboration with the Government Finance Officers Association (GFOA), recently published a brief overview of the LIBOR to SOFR transition which offers a catalog of tax and non-tax issues for bond issuers and borrowers to consider. A copy of that publication can be found here.
[4] Note that the principles of the proposed regulations described in this publication also apply to amendments or modifications of the terms of a tax-exempt bond or qualified hedge to provide a “fallback” rate to be used in the event LIBOR rates are no longer available in the future.
[5] The same rule applies to “associated alterations”, which are alterations related to the substitution of a qualified rate for a LIBOR-referencing rate that are reasonably necessary to adopt or implement the substitution. An example of an “associated alteration” is the addition of a provision in the bond or swap documents that requires one party to make a one-time payment to the other in connection with the substitution of a successor to the LIBOR-referencing rate, to offset the change in value of the instrument that would otherwise result from the substitution.
[6] As a corollary, the proposed regulations note that if the terms of a debt or hedging instrument are altered or modified to accomplish a LIBOR substitution to which the special rule of the proposed regulations applies and are also altered or modified for other purposes, the alteration or modification implementing the LIBOR substitution is treated as part of the existing terms of the instrument and constitutes part of the “baseline” against which the general reissuance principles of federal tax law are tested with respect to the other changes.
[7] Other specified reference rates that are treated as “qualified rates” under the proposed regulations are (i) the Sterling Overnight Index Average (SONIA), (ii) the Tokyo Overnight Average Rate (TONAR or TONA), (iii) the Swiss Average Rate Overnight (SARON), (iv) the Canadian Overnight Repo Rate Average (CORRA), (v) the Hong Kong Dollar Overnight Index (HONIA), (vi) the interbank overnight cash rate administered by the Reserve Bank of Australia (RBA Cash Rate) and (vii) the short-term rate administered by the European Central Bank (€STR). Generally, a compound of any of these qualified rates (such as a multiple of a specified reference rate, a 30-day average of such a rate, or a rate determined by adding or subtracting a specified number of basis points to such a rate) also can be treated as a “qualified rate”.