On October 12, 2020, the Internal Revenue Service issued Revenue Procedure 2020-44 (the Revenue Procedure) providing additional guidance related to the transition from an interbank offered rate (IBOR) to another replacement rate. Previously, the government issued proposed regulations on October 9, 2019 (the Proposed Regulations), which provide that a transition from an IBOR to another replacement rate would not cause a taxable event for holders, issuers or counterparties as long as certain requirements were met. As discussed in further detail below, the Revenue Procedure provides further guidance with respect to the modification of a contract to include a provision that provides a mechanism for the contract's reference rate to change from an IBOR to one or more replacement rates (a fallback provision).
IBORs are average rates at which certain banks can borrow in the interbank market that have been used to determine interest rates on a variety of financial products, such as loans, mortgages and derivatives. The London Interbank Offered Rate (LIBOR) is the most common IBOR. In 2017, the U.K. Financial Conduct Authority announced that it would not require banks to provide LIBOR submissions after 2021. In response, the Federal Reserve Board and the New York Fed convened a group of market participants, the Alternative Reference Rates Committee (ARRC), to identify an alternative reference rate and make recommendations to mitigate risks with respect to the cessation of LIBOR. In June 2017, ARRC identified the Secured Overnight Financing Rate (SOFR), a rate that measures the cost of borrowing cash overnight collateralized by Treasury securities, as the preferred benchmark replacement for the United States. Absent guidance such as the Proposed Regulations, modifications of debt instruments or other contracts, such as derivatives, to transition from an IBOR to an alternative reference rate, such as SOFR, could be viewed as an exchange of the original contract for the modified contract, which could result in the recognition of taxable gain or loss under section 1001.1
In response to the Proposed Regulations, ARRC submitted written comments to the government in which it recommended issuing guidance that is separate from the Proposed Regulations and specific to certain fallback provisions. As ARRC noted, many existing contracts already contain fallback provisions, but those provisions do not adequately protect against the cessation of LIBOR. To assist in providing a transition from LIBOR to SOFR, ARRC published recommended fallback provisions (ARRC Fallback Provisions) for inclusion in the terms of five categories of debt instruments: adjustable rate mortgages, bilateral business loans, floating rate notes, securitizations and syndicated loans. The ARRC Fallback Provisions provide a mechanism for determining the replacement rate that supplants the current benchmark rate used in the debt instrument. The ARRC Fallback Provisions also provide a mechanism for determining the spread adjustment that is added to the replacement benchmark rate to account for any difference between the replacement benchmark rate and the current benchmark rate. While ARRC anticipates that parties to newly issued contracts will utilize an ARRC Fallback Provision, it is anticipated that parties to outstanding contracts will also modify their contracts to incorporate an ARRC Fallback Provision.
Standard form documents published by the International Swaps and Derivatives Association (ISDA) form the basic framework of many derivative contracts. In consultation with ARRC, ISDA published a supplement to its documents that amends the fallback provisions in such documents to provide that a substitute rate identified in the ISDA supplement will replace LIBOR (ISDA Fallback Provision). Derivative contracts entered into on or after the effective date of the ISDA supplement generally include the ISDA Fallback Provision. In addition, ISDA published a protocol for amending legacy derivative contracts to include the ISDA Fallback Provision. If parties adhere to the ISDA protocol, all covered derivative contracts between the parties are modified to incorporate the ISDA Fallback Provision.2 Alternatively, parties may amend legacy derivative contracts to include the ISDA Fallback Provision on a transaction-by-transaction basis pursuant to bilateral agreements.
In its comments, ARRC recommended the addition of a "fast track" provision to the Proposed Regulations that would treat the incorporation of an ARRC Fallback Provision, the ISDA Fallback Provision or a provision substantially similar to either such fallback provisions as not a recognition event without the need to satisfy the tests set forth in the Proposed Regulations. In addition, because the fallback provisions operate by providing a multistep hierarchy or "waterfall" rather than a single replacement rate, the ARRC comments recommended a clarification that a hierarchy or waterfall such as the ARRC Fallback Provisions or the ISDA Fallback Provision would meet the requirement under the Proposed Regulations of "a qualified rate."
Integrated and Hedging Transactions
A debt instrument and one or more derivative contracts may be treated in certain circumstances as a single, integrated instrument. Similarly, regulations provide the method of accounting used by a taxpayer with respect to a transaction that qualifies as a hedging transaction. When a debt instrument and a derivative are integrated, a modification or termination of the derivative or debt instrument that is part of the integrated transaction may result in a "legging out" of the transaction or otherwise result in the acceleration of the recognition of gain. Similarly, the termination of one or more hedging transactions may result in unfavorable tax consequences, such as accelerating the recognition of gain. In its comments, ARRC recommended guidance providing that the modification of an integrated transaction or hedging transaction to incorporate an ARRC Fallback Provision or ISDA Fallback Provision, including variations of those provisions, would not result in a "legging out" of the integrated transaction or terminating either leg of a transaction subject to the hedge accounting rules, such that any adverse tax consequences would be avoided.
The Revenue Procedure
The Revenue Procedure generally adopts ARRC's recommended guidance with respect to both fallback provisions and integrated and hedging transactions. The Revenue Procedure applies to any contract with terms that reference an IBOR and that is modified to incorporate an ARRC Fallback Provision, an ISDA Fallback Provision or either of the provisions with certain prescribed deviations. The Revenue Procedure permits the following deviations to an ARRC Fallback Provision or an ISDA Fallback Provision: (i) from the terms of an ARRC Fallback Provision or an ISDA Fallback Provision, deviations reasonably necessary to make the terms incorporated into the contract legally enforceable in the relevant jurisdiction; (ii) from the terms of an ISDA Fallback Provision, deviations reasonably necessary to incorporate the provision into a contract that is not covered by the ISDA Protocol; (iii) from the terms of an ARRC Fallback Provision or an ISDA Fallback Provision, deviations to omit terms of the provision that cannot under any circumstances affect the operation of the modified contract; and (iv) from the terms of an ARRC Fallback Provision or an ISDA Fallback Provision, deviations to add, revise or remove technical, administrative or operational terms, provided that the changes are reasonably necessary to adopt or implement the fallback provision. The last category of permitted deviations does not include the addition of a term that obligates one party to make a one-time payment (or similar payments) as a substitute for any portion of an ARRC Fallback or an ISDA Fallback or as consideration for the modification.
Under the Revenue Procedure, if a contract is modified to incorporate an ARRC Fallback Provision, an ISDA Fallback Provision or either type of provision with a deviation described above, the modification will not be treated as a recognition event under section 1001. The Revenue Procedure also clarifies that if a contract is part of an integrated transaction or hedging transaction, a modification to add an ARRC Fallback Provision, an ISDA Fallback Provision or either type of provision with a prescribed deviation will not be treated as a legging out of the integrated transaction or the termination of either leg of a hedging transaction. Finally, the Revenue Procedure provides that to the extent a contract is contemporaneously modified in a manner not described in the Revenue Procedure (a non-covered modification) in addition to modifications addressed in the Revenue Procedure (a covered modification), the covered modification is treated as part of the existing terms of the contract against which the non-covered modifications and any other contemporaneous, subsequent or cumulative modifications are tested to determine whether the non-covered modification results in a recognition event under section 1001.
The Revenue Procedure provides welcome guidance by making clear that when a contract is modified to include an ARRC Fallback Provision or ISDA Fallback Provision, such modification should not result in the recognition of gain or loss. The Revenue Procedure is effective for modifications to contracts occurring on or after October 9, 2020, and before January 1, 2023. However, a taxpayer may rely on the Revenue Procedure for modifications that occurred before October 9, 2020.
1 Unless otherwise indicated, all "section" references are to sections of the Internal Revenue Code of 1986, as amended.
2 The ISDA Fallback Provision appears as an attachment to the protocol
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