Treasury Unveils Proposed Regulations to Resolve Tax Questions Related to LIBOR Cessation

The Treasury Department on Monday released proposed regulations to clarify the tax consequences of replacing the expiring London Inter-bank Offered Rate (LIBOR) in existing financial contracts, including real estate loans. The proposed rules largely align with Roundtable recommendations submitted over the summer. (Roundtable LIBOR letter, June 6 and Roundtable Weekly, June 7)

  • LIBOR is used as a reference rate in an estimated $200 trillion of financial contracts, including $1.3 trillion of commercial real estate loans.  In response to concerns regarding manipulation of LIBOR, UK financial authorities are phasing it out; LIBOR is expected to cease operation as working interest rate index by 2021. 
  • The replacement of LIBOR in existing agreements presents important tax questions.  “If the terms of a debt instrument are significantly modified, for Federal income tax purposes there is a deemed exchange of the old debt for a new (modified) debt instrument,” wrote Roundtable President and CEO Jeffrey DeBoer in the organization’s June 6 comment letter
  • Without relief, this deemed exchange could trigger the recognition of taxable gain or loss for the lender, or debt discharge income for the borrower.  “Moreover, the tax consequences of the deemed exchange can arise without generating actual cash to pay any ensuing tax liability,” continued DeBoer.  
  • As The Roundtable had recommended, the Treasury’s proposed regulations give borrowers and lenders the flexibility they need to replace LIBOR with virtually any other index that reflects objective changes in the cost of borrowing money – such as a broad index of Treasury or corporate borrowing rates – in addition to a list of rates suggested by various regulators. 
  • Don Susswein (RSM), a member of the Roundtable’s Tax Policy Advisory Committee (TPAC) and one of the architects of The Roundtable’s comments, noted, “The key to the flexibility is a reasonable safeguard to ensure that the parties are acting in good faith primarily to preserve their original deal—not modifying it to compensate for changed circumstances.”
  • As a safeguard to prevent potential abuse, the proposed regulations require that the fair market value of the modified instrument be “substantially equivalent” to its value before modification.  
  • Another key TPAC member, Joe Forte (Sullivan & Worcester) said, “It is clear that the hesitation of many market participants to transition from LIBOR to SOFR has been uncertainty concerning the tax and accounting treatment of the rate modification. Following on FASB’s Exposure draft on reference rate reform last month, the new Treasury/IRS guidance addressing the tax consequences of rate modification of cash contracts and derivatives has proposed two safe harbors similar to those The Roundtable proposed.”
  • “The Treasury and IRS deserve high marks for proposing a sound, rational framework early in the LIBOR transition to address with these challenging issues and remove tax uncertainty,” said DeBoer.  

Comments on the proposed rules are due by November 25, 2019.  Taxpayers may rely immediately on the proposed rules when evaluating the tax consequences of an alteration of the terms of a loan or other contract, provided the taxpayer consistently applies the rules. 

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Roundtable Urges Treasury to Clarify Tax Consequences of Transition Away from LIBOR as Reference Rate

The Real Estate Roundtable yesterday asked the U.S. Treasury Department and IRS to reduce the risk of market disruption by clarifying the tax treatment of financial contracts that replace the expiring London Inter-bank Offered Rate (LIBOR) with a substitute reference rate.  Over $200 trillion of LIBOR contracts are outstanding, including roughly $1.3 trillion of commercial real estate debt. (Roundtable LIBOR letter, June 6)

The Real Estate Roundtable yesterday asked the U.S. Treasury Department and IRS to reduce the risk of market disruption by clarifying the tax treatment of financial contracts that replace the expiring London Inter-bank Offered Rate (LIBOR) with a substitute reference rate. (Roundtable LIBOR letter, June 6)

  • The United Kingdom’s Financial Conduct Authority (FCA), which regulates LIBOR, announced in 2017 that it is phasing out the global borrowing index by the end of 2021.  LIBOR will need to be replaced in both new agreements and innumerable existing legacy contracts.
  • Several factors may necessitate or accelerate parties’ adoption of alternative reference rates on existing contracts well before the end of 2021.  To facilitate the transition, the Federal Reserve Bank of New York in 2018 began publishing an alternative U.S. benchmark to work alongside LIBOR – the Secured Overnight Financing Rate (SOFR).  (See: A User’s Guide to SOFR  and SOFR: A Year in Review)
  • However, several issues may be contributing to the reluctance of market participants to use SOFR, including the absence of necessary internal infrastructure to support its accounting and trading, and the lack of tax guidance. 
  • Roundtable President and CEO Jeffrey DeBoer noted in the comment letter, “If the terms of a debt instrument are significantly modified, for Federal income tax purposes there is a deemed exchange of the old debt for a new (modified) debt instrument.”  Without relief, this deemed exchange could trigger the recognition of taxable gain or loss for the lender, or debt discharge income for the borrower.
  • “Moreover, the tax consequences of the deemed exchange can arise without generating actual cash to pay any ensuing tax liability,” wrote DeBoer. 

    Randal Quarles – the Fed’s vice chairman in charge of financial regulation – reiterated the urgency of moving forward on the transition to SOFR

  • The Roundtable’s June 6 comments recommend that a safe-harbor rule confirm that a replacement index or formula identified by regulators, broad industry groups, or similar objective sources-or by the parties themselves in good faith-is not considered an alteration or modification of the original instrument.  The Roundtable letter states, “Instead, the replacement should be treated for Federal tax purposes as a continuation of the instrument’s original terms.”
  • This week, Randal Quarles – the Fed’s vice chairman in charge of financial regulation – reiterated the urgency of moving forward on the transition to SOFR:  “I believe that the ARRC has chosen the most viable path forward and that most will benefit from following it, but regardless of how you choose to transition, beginning that transition now would be consistent with prudent risk management and the duty that you owe to your shareholders and clients …. With only two and a half years of further guaranteed stability for LIBOR, the transition should begin happening in earnest.”  (Bloomberg, June 3)
  • The Wall Street Journal reported last July that companies were adopting SOFR sparingly –  despite regulators urging banks and traders to stop launching new Libor-based contracts ahead of the 2021 deadline. (WSJ, July 12 and Roundtable Weekly, July 13, 2018) 

The Roundtable letter was developed by a task force that included Tax Policy Advisory Committee (TPAC) Chairman Frank Creamer Jr., TPAC member Don Susswein, and chair of the Real Estate Capital Policy Advisory Committee (RECPAC) Working Group on LIBOR, Joseph Philip Forte.  On June 11, at The Roundtable’s Annual Meeting in Washington DC, Joseph Forte will lead a RECPAC discussion on real estate’s concerns with the LIBOR transition. 

Regulators Emphasize Need for Transition Away From LIBOR to New Standard by End of 2021; Roundtable to Address Impact on Commercial Real Estate Finance

International regulators this week urged banks to speed up their transition plans away from the London Inter-bank Offered Rate (LIBOR) to a new standard for setting the price of trillions of dollars of loans and derivatives worldwide. LIBOR is an important reference rate for commercial real estate and the broader economy, underlying approximately $373 trillion worth of cash and derivative contracts globally. 

The Fed’s Alternative Reference Rates Committee (ARRC) will meet on July 19 to address risks in contract language and actions that could minimize disruptions associated with a possible end to LIBOR.

  • With LIBOR set to expire at the end of 2021, the status of reform efforts and their impact on commercial real estate finance is profiled by Joseph Forte (Sullivan & Worcester) – a member of The Roundtable’s Real Estate Capital Policy Advisory Committee (RECPAC) – in his recent article, “Après LIBOR: Black Swan or Y2K.” 
  • LIBOR’s credibility was badly undermined a decade ago by a rate-manipulation scandal. These illegal actions damaged the public’s trust in LIBOR, financial markets and institutions. 
  • The United Kingdom’s Financial Conduct Authority (FCA), which regulates LIBOR, announced last year that it will phase out the global borrowing index by 2021.  In December 2018, FCA Chief Executive Andrew Bailey said, “There is some good news to report on the important steps taken towards transition. But the pace of that transition is not yet fast enough. There is much further to go.”  (FCA, “Interest rate benchmark reform: transition to a world without LIBOR“) 

    With LIBOR set to expire at the end of 2021, the status of reform efforts and their impact on commercial real estate finance is profiled in Joseph Forte’s recent article, ” Après LIBOR: Black Swan or Y2K .” 

  • The Federal Reserve Bank of New York in April began publishing an alternative U.S. benchmark to work alongside LIBOR – the Secured Overnight Financing Rate (SOFR), which is seen as the next step to transition trillions of dollars in securities away from LIBOR.  SOFR is seen as more reliable, as it is based on interest rates in the U.S. market for repurchase agreements instead of LIBOR’s estimated quotes by bankers in the relatively thin interbank loan market. 
  • Yesterday, The Wall Street Journal reported that international regulators are urging banks to stop using LIBOR for new contracts and plan to accommodate legacy contracts that are set to expire after LIBOR sunsets at the end of 2021.  “Legacy contracts represent arguably the greatest challenge for regulators and industry groups,” according to the July 13 article.   
  • Former President of the Federal Reserve Bank of New York William Dudley spoke about LIBOR in May. “Time is of the essence, and we must manage it well,” he told a Bank of England forum.  “Because of the great uncertainty over LIBOR’s future and the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates, we need aggressive action to move to a more durable and resilient benchmark regime,” Dudley added.  (Reuters, May 24, 2018) 
  • The Fed’s Alternative Reference Rates Committee (ARRC) will meet on July 19 to address risks in contract language and actions that could minimize disruptions associated with a possible end to LIBOR.  See “Alternative Reference Rates Committee Releases Principles for Fallback Contract Language Guiding Principles Mark a Key Milestone in Meeting the ARRC’s Mandate” and the ARRC website for additional information. 

The Roundtable’s RECPAC has formed a LIBOR Working Group to address this challenge and work toward the development and implementation of an effective, new replacement benchmark that does not impair liquidity, needlessly increase borrowing costs or cause market disruptions.