IRS Proposed Regulations Regarding LIBOR Phase Out
By: Jennifer M. Egan, Esq.
On July 27, 2017, the U.K. Financial Conduct Authority announced that the London interbank offered rate (LIBOR) may be phased out after the end of 2021. Many tax-exempt bonds and interest rate swaps use a LIBOR-based interest rate. If such instruments are modified to replace the LIBOR index with another interest rate index, tax consequences can arise, such as triggering a reissuance of tax-exempt bonds or a deemed termination of a swap. Therefore, on October 8, 2019, the IRS issued proposed regulations (the “Proposed Regulations”) related to such issue. The Proposed Regulations provide relief from such tax consequences.
The Proposed Regulations provide that amending the terms of tax-exempt bonds or interest rate swaps (“Tax-Exempt Instruments”) to replace LIBOR with a “qualified rate” will not trigger a reissuance of tax-exempt bonds or be deemed a termination of the swap if the fair market value of the modified Tax-Exempt Instruments is substantially equal to the fair market value of the Tax-Exempt Instruments prior to being revised.
There are eleven categories for “qualified rates” under the Proposed Regulations, including, a much discussed Secured Overnight Financing Rate published by the Federal Reserve Bank of New York (SOFR), and future possible “qualified rates” as published in the Internal Revenue Bulletin.
To ensure that the modifications to Tax-Exempt Instruments are no broader than is necessary to replace the LIBOR index, the Proposed Regulations require the above-mentioned fair market value test. The fair market value may be determined by any reasonable valuation method, as long as that reasonable valuation method is applied consistently and takes into account any one-time payment made in lieu of a spread adjustment. The Proposed Regulations currently provide two safe harbors for determining the fair market value.
The first safe harbor is met if at the time of the modification of the Tax-Exempt Instrument, the historic average of the LIBOR rate is within 25 basis points of the historic average of the rate that replaces it. The parties may use any reasonable method to compute a historic average subject to two limitations: (i) the lookback period from which the historic data are drawn begins no earlier than 10 years before the modification and ends no earlier than three months before such modification, and (ii) once a lookback period is established, the historic average must take into account every instance of the relevant rate published during that period. Alternatively, the parties may compute the historic average of a rate in accordance with an industry-wide standard, such as set forth by the International Swaps and Derivatives Association or the Alternative Reference Rates Committee. In either application of this safe harbor, the parties must use the same methodology and lookback period to compute the historic average for each of the rates to be compared.
The second safe harbor is met if the parties to the Tax-Exempt Instrument are not related, and through bona fide, arm’s length negotiations over the modification of such document, determine that the fair market value of the modified Tax-Exempt Instrument is substantially equivalent to the fair market value of the Tax-Exempt Instrument before such modification. In determining the fair market value, the parties must take into account the value of any one-time payment made in lieu of a spread adjustment.
Furthermore, if the fair market value test is satisfied, any additional modification made in association with the replacement of the interest rate that is reasonably necessary to implement such a replacement, will not trigger a reissuance or be deemed a termination of a swap. This includes a one-time payment to the other in connection with the replacement of the LIBOR rate to offset the change in value that occurs as a result of the replacement.
Generally the final regulations ultimately adopted would apply to a modification of Tax-Exempt Instruments that occurs on or after the date of publication of the final regulations in the Federal Register. However, a taxpayer may choose to apply certain portions of the Proposed Regulations to modifications that occur before that date, provided that the taxpayer and its related parties consistently apply such rules before that date.
It is important to analyze your current outstanding debt instruments to see if there are any that have LIBOR-based interest rate. If so, your analysis should consider working with the other party to the agreement to modify such instrument in compliance with the Proposed Regulations, or, determine if it is best to wait until the final regulations are published. If you need assistance determining which steps to take in working through the process of replacing LIBOR in your Tax-Exempt Instruments, please contact Jennifer M. Egan at jegan@uks.com or 860-548-2628.
As part of her public finance practice, Mrs. Egan represent municipalities, underwriters, trustees, letter of credit banks and purchasers in general obligation bond, refunding bond and revenue bond financing transactions.