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SOFR So Good! IRS Makes It Easier to Say ‘Goodbye’ to LIBOR

Lenders, creditors and swap parties may finally begin to replace LIBOR with confidence. While LIBOR’s demise was announced in 2017, efforts to amend the vast pool of LIBOR-based bonds and swaps to reference a replacement index and spread have been hampered by concern that such amendments to the interest rate might trigger reissuance of bonds and tax realization events for holders. The Department of Treasury and Internal Revenue Service (IRS) announced Proposed Regulations on October 8, 2019 (which can be relied on immediately) that provide welcome guidance for amendments replacing a LIBOR-based rate that will avoid such reissuance and tax realization events.

The Proposed Regulations appear to accomplish their stated goal of facilitating the orderly transition from LIBOR with minimum cost and disruption to the market in that they provide that the alteration of the terms of a debt instrument or a non-debt contract (such as a hedge) to replace an IBOR-referencing rate with a “qualified rate,” and any “associated alteration,” will generally not result in adverse tax consequences.


Interbank offered rates (IBORs) are benchmark interest rates that are set based on the rates at which banks lend to and borrow from one another on the interbank market. The London interbank offered rate (LIBOR) is the most widely used IBOR and a very large volume of U.S. financial products and contracts, including bonds, loans and derivatives, have rates and terms that are based on LIBOR, typically a stated percentage of LIBOR and/or a fixed number of basis points, or “spread,” over LIBOR. Concern about manipulation and a decline in the volume of interbank transactions of the type LIBOR is intended to indicate led to recommendations for developing alternatives to LIBOR. In 2017, United Kingdom regulators announced that all currency and term variants of LIBOR, including USD LIBOR, may be phased out after 2021 and no longer published.

The Alternative Reference Rates Committee (ARRC) was convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York to identify alternative reference rates that would be more reliable than USD LIBOR and to develop a plan to facilitate the voluntary acceptance of the alternative reference rate or rates that were identified. The Secured Overnight Financing Rate (SOFR) was selected by ARRC as the preferred replacement for USD LIBOR and the Federal Reserve Bank of New York began publishing SOFR daily as of April 3, 2018.

On or before the date on which LIBOR rates cease to be published, most existing debt instruments and derivatives that reference LIBOR in setting a variable rate will need to be amended to provide for alternative rate setting mechanisms, as the typical rate-setting provisions provide for temporary unavailability of a published LIBOR rate but not for its permanent cessation. These necessary amendments may include the replacement of a LIBOR-based rate that is in effect with a substitute rate, and may also include replacement of LIBOR-based fallback rates. A substitute variable rate will likely require a substitute index, such as SOFR, and a different percentage of and/or spread to that index from the one currently in effect. ARRC, together with industry groups, urged IRS and Treasury to provide broad and flexible tax guidance regarding the transition away from LIBOR to minimize market disruption.

Without the Proposed Regulations, amendments to existing debt instruments would need to be tested for significance under section 1001 of the Internal Revenue Code. The regulations under section 1001 generally provide that gain or loss is realized upon the exchange of property differing materially in kind or extent. A significant modification of a debt instrument results in a deemed exchange of the original debt instrument for a modified debt instrument. Under the existing regulations, the general rule is that the determination of whether a modification is significant depends on all of the facts and circumstances. A modification resulting in a change in yield of more than the greater of 25 basis points or five percent of the yield of the unmodified debt instrument is treated as a significant modification. Determination of whether a change in index rate or change in fallback provision would be a significant modification could be costly and disruptive to the market.

The replacement of an existing bond with a significantly modified new bond is commonly referred to as a “reissuance.” Reissuance of a bond is treated as a current refunding for tax purposes and the continued tax-exemption of the bond after the reissuance date must be reassessed by reference to tax law requirements and factual circumstances in effect as of the reissuance date. For a tax-exempt instrument, a reissuance requires the filing by the issuer of a new information return with the IRS, and generally requires a new tax-exemption opinion, which requires tax diligence by the opining counsel. In some instances, intervening changes in tax law may preclude reissuance of a debt instrument on a tax-exempt basis. As noted above, a reissuance may also result in the realization of tax loss or gain as of the reissuance date by the holder of the reissued bond.

There are no regulations that specifically address whether a modification of an interest index in a derivative or other non-debt contract would create a tax realization event. The absence of regulations has led to a concern that any modification of a derivative or other non-debt contract to reflect the elimination of LIBOR, such as a change from a LIBOR-based rate to a SOFR-based rate, could cause a deemed termination of the derivative or other non-debt contract for tax purposes.

Proposed Regulations

The preamble to the Proposed Regulations notes that “there is no underlying economic rationale for a tax realization event” in connection with the transition away from IBOR reference rates. Accordingly, the Proposed Regulations provide welcome relief.

Under the Proposed Regulations, alteration of the terms of a debt instrument or a non-debt contract (such as a hedge) to replace an IBOR-referencing rate with a “qualified rate,” and any “associated alteration,” will not be treated as a modification resulting in the realization of income, deduction, gain, or loss for purposes of section 1001. This will be true regardless of whether the modifications are made through an amendment of the original instrument or by an exchange of a new instrument for the original instrument.

Associated Alteration

An associated alteration is defined as any technical, administrative or operational alteration of a debt instrument or a non-debt contract that is reasonably necessary to adopt or to implement a replacement of an IBOR-referencing rate with a qualified rate. Examples include changes to the definition of interest period, changes to the timing and frequency of determining rates and making payments of interest, and the addition of an obligation for one party to make a one-time payment to offset the change in value of the debt instrument or non-debt contract that results from the replacement. See “Other Contemporaneous Alterations” below regarding treatment of alterations that are not associated alterations.

Qualified Rates

A qualified rate is defined as SOFR, certain rates of other jurisdictions associated with their respective currencies, any other qualified floating rate as defined in section 1.1275-5(b)(but without regard to the limitations on multiples set forth therein), any rate that is determined by reference to a rate previously described as a qualified rate (including a rate determined by adding or subtracting a specified number of basis points to or from the rate or by multiplying the rate by a specified number), or any other rate identified as a qualified rate in future guidance published in the Internal Revenue Bulletin.

A rate is a qualified rate only if (i) the fair market value of the debt instrument or non-debt contract after the modification is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the modification, and (ii) the interest rate benchmark after the modification is based on transactions conducted in the same currency as the original IBOR rate.

Fair Market Value

Recognizing that fair market value may be difficult to precisely determine, the Proposed Regulations establish two safe harbors for determining that the fair market value of the debt instrument or non-debt contract after the modification is substantially equivalent to the fair market value of the debt instrument or non-debt contract before the modification.

The first safe harbor is satisfied if the historic average of the relevant IBOR-referencing rate does not differ from the historic average of the replacement rate by more than 25 basis points, taking into account any spread or other adjustment to the rate and adjusted to take into account the value of any one-time payment that is made in connection with the modification. The historic average of a rate may be determined by any reasonable method that takes into account every instance of the rate published during a continuous period beginning no earlier than 10 years before the modification and ending no earlier than three months before the modification. The historic average must be determined for both rates using the same method. SOFR has a limited history so this safe harbor may be less useful for transitions to SOFR.

The second safe harbor is satisfied if the parties to the debt instrument or non-debt contract are not related and the parties determine, based on bona fide arm’s length negotiation, that the fair market value of the debt instrument or non-debt contract before the modification is substantially equivalent to that after the modification, taking into account the value of any one-time payment made in connection with the modification. Presumably, this safe harbor will be satisfied if the parties certify as to their determination at the time of the modification.

Effect on Integrated Hedges

The Proposed Regulations provide that modifications to integrated hedges to replace an IBOR-referencing rate with a qualified rate will not affect the tax treatment of either the underlying transaction or the hedge, provided that the hedge as modified continues to qualify for integration under the applicable regulations.

Other Contemporaneous Alterations

Any other contemporaneous changes to the terms of a debt instrument or non-debt contract that are broader than necessary to change the reference rate, and are therefore not associated alterations, are analyzed under existing guidance and, in connection with that analysis, the changes in reference rate are treated as if they had been in place at the time the additional changes are made.

Optional Application

The Proposed Regulations will apply to alterations of debt instruments or modifications of non-debt contracts that occur on or after the date of publication (following comments and any revisions) as final regulations in the Federal Register. The Proposed Regulations may be applied to alterations of debt instruments or modifications of non-debt contracts that occur before that date, provided that the Proposed Regulations are consistently applied.

Comments and requests for a public hearing must be received by November 25, 2019.

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About this Author

Christie L. Martin Member Public Finance Tax Tax-Exempt Bond Controversy Resolution Government / Quasi Government Financings Affordable Housing Financing

Christie counsels government entities and 501(c)(3) organizations as well as investment bankers and banks in connection with the tax-exempt financing of projects for public and nonprofit organizations. Her practice focuses on municipal finance–related federal tax law relevant to the issuance of general obligation bonds, qualified 501(c)(3) private activity bonds, exempt facility bonds, tax revenue anticipation, and other working capital bonds and tax credit bonds.

Christie often acts as counsel to issuers and borrowers in connection with IRS...

Leonard Weiser-Varon Coporate and Finance Law Attorney Mintz Law Firm

Len specializes in municipal and corporate debt transactions,  represents state sponsors and private program managers of Section 529 college savings programs and Section 529A (ABLE) disability savings programs, and is often invited to speak on securities and constitutional law issues impacting finance. He also regularly writes on public finance matters and has been recognized as one of the top public finance lawyers in Massachusetts in a peer survey by Massachusetts Super Lawyers.

Len is active in both municipal finance and corporate finance, with an emphasis on financings for 501(c)(3) institutions, project finance, secured lending, structured finance transactions, workouts and restructurings, corporate debt, Section 529 college savings programs, and Section 529A (ABLE) disability savings programs.

His practice includes service as bond counsel, issuer’s counsel, underwriters’ counsel, and counsel to institutional purchasers and borrowers in connection with public offerings and private placements of, and defaults and bankruptcies involving, tax-exempt and taxable debt for public, nonprofit, and corporate entities. Len also serves as state sponsor’s counsel and program manager’s counsel on various Section 529 and Section 529A (ABLE) programs. He also is experienced in obtaining SEC no-action letters and negotiation of IRS closing agreements.

Len is a panelist on securities and constitutional law matters and on Section 529 and ABLE programs, and has published articles and edited textbooks on a variety of finance-related topics.

Before joining the Mintz Law Firm, Len clerked for Associate Justice Ruth I. Abrams of the Supreme Judicial Court of Massachusetts.

Matthew O. Page Associate Boston Public Finance Education & Health Care Financings Government / Quasi Government Financings Tax-Exempt Bond Controversy Resolution

Matt’s practice focuses exclusively on public finance matters. His experience extends into all aspects governmental and nonprofit debt finance—including acting as bond counsel, disclosure counsel, and counsel to borrowers, issuers, lenders, remarketing agents, trustees and underwriters—in connection with fixed rate, variable rate and multimodal debt.

As bond counsel, Matt has advised numerous governmental entities—including cities, towns, counties and states, transportation authorities and school, water, fire and wastewater districts—in connection with the issuance of taxable and...