Borrowers of tax-exempt debt across the country with outstanding bond issuances tied to the London Interbank Offered Rate (“LIBOR”) are working to amend their financial instruments to account for the cessation of the rate’s publication after June 30, 2023. To address and limit the anticipated impacts associated with the cessation of LIBOR, the Treasury Department (the “Treasury”) and the Internal Revenue Service (the “IRS”) published final regulations on January 4, 2022 (the “Final Regulations”). The Final Regulations provide guidance on the tax consequences of the transition away from LIBOR-based interest rates in debt instruments, derivatives and other contracts to other recognized rates.¹
Depending on the nature of the change, modifying the terms of a tax-exempt bond can constitute a “significant modification” that leads to a “reissuance” of the bond. A reissuance of the bond may then trigger the need for the borrower or the issuer to take additional procedural action (such as the filing of an IRS Form 8038, the giving of an opinion, etc.) that otherwise would not be necessary. However, under the Final Regulations, if a modification of a LIBOR-based instrument is made within a year of the discontinuation of the rate in question and meets certain other requirements, then the change may qualify as a “Covered Modification” and avoid triggering a reissuance.
Elements of a Covered Modification
Per Treas. Regs. 1.1001-6(b) and 1.1001-6(j), a “Covered Modification” to the index rate under a LIBOR-based financing instrument (1) includes modifications that:
(a) Replace the current applicable LIBOR rate;
(b) Add a fallback rate where the current rate is a LIBOR rate;
(c) Replace a fallback rate that currently references a LIBOR rate; or
(d) Implement fallback language approved by the Alternative Reference Rates Committee (“ARRC”) (as contemplated in Rev. Proc. 2020-44); and (2) excludes modifications that change the amount or timing of contractual cash flows:
(a) With the intent to induce one or more parties to perform an act necessary to consent to a contract modification described in items (1)(a) – (c) above;
(b) With the intent to compensate one or more parties for a contract modification not described in items (1)(a) – (c) above;
(c) Such that the change is either a concession granted to a party experiencing financial difficulty or a concession secured by a party to account for another party’s credit deterioration;
(d) With the intent to compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified; or
(e) Such that the modification is identified for purposes of Treas. Regs. 1.1001-6(j)(5) in guidance published in the Internal Revenue Bulletin as having a principal purpose of achieving an unreasonable result.
Per Treas. Reg. 1.001-6(h)(2), any modifications that do not meet the requirements identified under items (1) and (2) above are “Noncovered Modifications.”
Additionally, in implementing the Covered Modification, the replacement index rate (and each rate in a “waterfall of rates,” if applicable) must be a “Qualified Rate.” A rate is a Qualified Rate if it is:
(i) A qualified floating rate (as defined in 1.1275-5, including SOFR, BSBY, or other variable rates that measure contemporaneous variations in the cost of borrowing money) the contemporary cost of borrower money);
(ii) An alternative rate that is selected by applicable governmental institutions as a replacement for a discontinued LIBOR;
(iii) A rate selected by the ARRC as a replacement for LIBOR;
(iv) A rate determined by reference to a rate described in 1 through 3 above (including a rate resulting from adding or subtracting a specified spread from such rates or by multiplying such rates by a specified number); or
(v) Any other rate that the Treasury determines to be a “qualified rate” in subsequent guidance.
Associated Modifications
Borrowers should be mindful that while the Final Regulations allow financing instruments to be amended to incorporate Covered Modifications, they do not provide unbridled freedom to simultaneously modify any other terms of the financing instrument. Treas. Reg. 1.1001-6(b)(2) provides that Noncovered Modifications made at the same time as Covered Modifications are subject to the regular tests for significant modifications (and therefore a reissuance) of Treas. Reg. § 1.1001-3. That being said, “Associated Modifications” may be implemented at the same time that Covered Modifications are made. Associated Modifications are changes of technical, administrative or operational terms that are reasonably necessary to adopt or implement Covered Modifications, and, if limited properly, should not constitute significant modifications or give rise to reissuance concerns. For example, an Associated Modification may be the addition of a new, defined term or a notice period provision, which merely relates to the amending/changing of a currently applicable LIBOR-based rate under a financing instrument.
Other Practical Takeaways
In determining whether a modification to a financing instrument relating to the cessation of LIBOR is warranted, borrowers should also take note of the following:
- Amendment May Not Be Required. Before proceeding to amend a financing instrument due to the cessation of LIBOR (especially in cases when asked to pay lender’s counsel fees or other costs to do so), borrowers should carefully review the terms of their existing documents to see what they say, if anything, about cessation or unavailability of LIBOR. In some instances, the existing provisions may be more favorable to the borrower or may be sufficient to meet the borrower’s needs. Accordingly, dependent on the language of the financing instrument in question (and notwithstanding a lending institution’s preference to amend the documents), it may not be necessary to amend the financing instrument due to the cessation of LIBOR.
- Replacement Rate Negotiability. If a borrower determines that it is necessary or preferable to make certain Covered Modifications to their financing documents, then they should be aware that banks generally have standard LIBOR replacement language, with limited options for borrowers to negotiate changes to that language, other than perhaps the spread. Law, regulation and industry practice have coalesced around using SOFR as the replacement benchmark. Other benchmarks, such as BSBY or Ameribor, are permitted but are less common and likely only to be used in a transaction where neither side prefers SOFR instead.
- ARRC Spread Parameters. In implementing a replacement benchmark, borrowers should be cognizant of the ARRC guidance on recommended spreads for replacing LIBOR with SOFR in March of 2021. Since that time, spread differentials between LIBOR and SOFR have been less than the ARRC’s recommended spread adjustments, so many borrowers have been able to negotiate spreads below these levels. Especially in light of current market conditions, a spread differential substantially in excess of the ARRC’s recommendations would suggest that something more than a mere LIBOR to SOFR replacement was occurring.
For more information regarding this topic, please contact:
- Your primary Hall Render contact.
References
1 While the Final Regulations address the cessation of all interbank offered rates (defined therein as “IBORs”), this article’s primary focus is the cessation of USD LIBOR which will no longer be published after June 30, 2023. Accordingly, this article replaces references to IBOR with LIBOR.
