In a Revenue Procedure (Rev Proc 2020-44, 2020-45 IRB), the IRS has provided that certain modifications to a contract with terms referencing a London Interbank Offered Rate (LIBOR), US-dollar LIBOR (USD LIBOR), or other interbank offered rates (together, IBORs) will not be treated as an exchange of property for other property differing materially in kind or extent for purposes of Reg §1.1001-1(a). In addition, the Revenue Procedure provides that such modifications will not be treated as a legging out of an integrated transaction, a termination of a qualified hedge, or as a disposition or termination of either leg of a hedging transaction.
Background. On July 27, 2017, the U.K. Financial Conduct Authority, the U.K. regulator tasked with overseeing the London interbank offered rate (LIBOR), announced that all currency and term variants of LIBOR, including U.S.-dollar LIBOR (USD LIBOR), may be phased out after the end of 2021. These IBORs are frequently referred to in the terms of debt instruments and non-debt contracts.
Reg § 1.1001-1(a) generally provides that gain or loss is realized upon an exchange of property for other property differing materially either in kind or in extent.
In 2019, the IRS issued proposed regs providing guidance on the tax consequences of modifying debt instruments, derivative contracts, and other contracts to replace IBORs or add fallback provisions to IBORs. See Proposed reliance regs on tax effects of phaseout of interbank offered rates (10/09/2019).
Guidance. In response to comments regarding the proposed regs provided by the Alternative Reference Rates Committee (ARRC), composed of US government officials, and the International Swaps and Derivatives Association (ISDA), a trade organization, the IRS concluded that interim guidance in advance of finalizing the proposed regs is needed. (Rev Proc 2020-44, Sec. 2.05, 2020-45 IRB)
The Revenue Procedure applies to any contract with terms that reference an IBOR and that are modified as described in Rev Proc 2020-44, Sec. 4.02 (discussed below). For this purpose, a contract includes but is not limited to a derivative contract, a debt instrument, stock, an insurance contract, and a lease agreement. (Rev Proc 2020-44, Sec. 4.01)
The Revenue Procedure applies to any of the following modifications:
(1) The contract is modified to incorporate an ISDA Fallback (as defined in Rev Proc 2020-44, Sec. 3.02), regardless of whether that modification results from adherence to the ISDA Protocol (posted by the ISDA at https://www.isda.org on October 9, 2020) or a bilateral agreement between the parties to the contract.
(2) The contract is modified to incorporate an ARRC Fallback (as defined in Rev Proc 2020-44, Sec. 3.01).
(3) The contract is modified to incorporate the terms of either an ARRC Fallback or an ISDA Fallback with certain deviations, provided all deviations fall into one or more of the following categories:
- (i) Deviations from the terms of an ARRC Fallback or an ISDA Fallback that are reasonably necessary to make the terms incorporated into the contract legally enforceable in a relevant jurisdiction or to satisfy legal requirements of that jurisdiction;
- (ii) Deviations from the terms of an ISDA Fallback that are reasonably necessary to incorporate the ISDA Fallback into a contract that is not a Protocol Covered Document (as defined in the ISDA Protocol);
- (iii) Deviations from the terms of an ARRC Fallback or an ISDA Fallback to omit terms of an ARRC Fallback or an ISDA Fallback that cannot under any circumstances affect the operation of the modified contract (e.g., for a contract that refers only to USD LIBOR, omission of the portions of an ISDA Fallback that relate exclusively to contracts referring to another IBOR); or
- (iv) Deviations from the terms of an ARRC Fallback or an ISDA Fallback to add, to revise, or to remove technical, administrative, or operational terms, provided that the addition, revision, or removal is reasonably necessary to adopt or to implement the ARRC Fallback or the ISDA Fallback. Examples of technical, administrative, or operational terms include the definition of interest period, the timing and frequency of determining rates, and the timing and frequency of making payments of interest. This Sec. 4.02(3)(iv) does not apply to 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. (Rev Proc 2020-44, Sec. 4.02)
If a contract described in Rev Proc 2020-44, Sec. 4.01, is modified as described in Rev Proc 2020-44, Sec. 4.02, then that modification is not treated as the exchange of property for other property differing materially in kind or extent for purposes of Reg §1.1001-1(a). For example, in the case of a debt instrument that is described in Rev Proc 2020-44, Sec. 4.01, and that is modified as described in Rev Proc 2020-44, Sec. 4.02, the modification is not treated as a significant modification for purposes of Reg §1.1001-3, which provides rules for determining whether the modification results in an exchange of the original debt instrument for a modified debt instrument that differs materially either in kind or in extent for purposes of Reg §1.1001-1(a). (Rev Proc 2020-44, Sec. 5.01)
If a contract described in Rev Proc 2020-44, Sec. 4.01, is one leg of a transaction integrated under Reg §1.1275-6 (providing for the integration of a qualifying debt instrument with a hedge or combination of hedges if the combined cash flows of the components are substantially equivalent to the cash flows on a fixed or variable rate debt instrument) or Reg §1.988-5(a) (providing rules whereby a “qualifying debt instrument” can be integrated with a Reg §1.988-5(a) hedge and the result is treated as a single, “synthetic,” debt instrument), then the modification of that contract as described in Rev Proc 2020-44, Sec. 4.02, is not treated as legging out (eliminating some component of a hedge, which would be considered a sale) of the integrated transaction under Reg §1.1275-6 or Reg §1.988-5(a). (Rev Proc 2020-44, Sec. 5.02)
If a contract described in Rev Proc 2020-44, Sec. 4.01, is integrated under Reg §1.148-4(h) (providing rules whereby hedged bonds are treated as fixed yield bonds paying a fixed interest rate if the issuer of variable yield bonds enters into a qualified hedge), then the modification of that contract as described in Rev Proc 2020-44, Sec. 4.02, is not treated as terminating the qualified hedge under Reg §1.148-4(h). (Rev Proc 2020-44, Sec. 5.02)
If a contract described in Rev Proc 2020-44, Sec. 4.01, is part of a hedging transaction described under Reg §1.446-4, then the modification of that contract as described in Rev Proc 2020-44, Sec. 4.02, is not treated as a disposition or termination of either leg of the transaction under Reg §1.446-4. (Rev Proc 2020-44, Sec. 5.02)
If a contract described in Rev Proc 2020-44, Sec. 4.01, is modified as described in Rev Proc 2020-44, Sec. 4.02 (covered modification), and is contemporaneously modified in a manner not described in Rev Proc 2020-44, Sec. 4.02 (noncovered modification), then the regs discussed above in Rev Proc 2020-44, Sec. 5.01 and Rev Proc 2020-44, Sec. 5.02 apply to the noncovered modifications without regard to the special rules provided in Rev Proc 2020-44, Sec. 5.01 and Rev Proc 2020-44, Sec. 5.02. In addition, when applying each reg discussed above in Rev Proc 2020-44, Sec. 5.01, and Rev Proc 2020-44, Sec. 5.02, the covered modifications are treated as part of the terms of the contract prior to any modification that is not a covered modification. As a result, covered modifications are treated as part of the existing terms of the contract against which other contemporaneous, subsequent, or cumulative modifications are tested under the regs discussed above in Rev Proc 2020-44, Sec. 5.01, and Rev Proc 2020-44, Sec. 5.02. (Rev Proc 2020-44, Sec. 5.03)
Effective date. The Revenue Procedure is effective for modifications to contracts occurring on or after October 9, 2020, and before January 1, 2023. A taxpayer, however, may rely on the Revenue Procedure for modifications to contracts occurring before October 9, 2020. (Rev Proc 2020-44, Sec. 6)
References: For treatment of modification of debt instruments as a sale or exchange, see FTC 2d/FIN ¶I-1058.
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