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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