USD LIBOR is the last step in the long and winding road that has been LIBOR’s slow demise over the last several years as all other LIBOR instruments worldwide have already substantially transitioned.

As taxpayers prepare for the termination of USD LIBOR on June 30, 2023, they should be mindful of key changes made in the final US Treasury regulations addressing the LIBOR transition. In light of the variations in some of the replacement benchmarks, the final Treasury regulations may have opened the door to previously unanticipated economic consequences.

Proposed Regulations

In July 2021, we published an alert on Revenue Procedure 2020-44 which, along with proposed regulations released on October 9, 2019, comprised the initial response of the US Treasury Department and the Internal Revenue Service (IRS) to the transition away from the London InterBank Offered Rate (LIBOR).

The alert summarized how contracting parties transitioning away from LIBOR were permitted to avoid US federal income taxation on the modification of contracts if certain requirements were satisfied. One such requirement was that the fair market value of a contract modified for purposes of the LIBOR transition be “substantially equivalent to the fair market value” of the original contract to qualify for the exception to the significant modification rules.

Dramatic Change in Final Regulations

The final regulations made two key changes: (i) removing the economic equivalency test and (ii) approving certain benchmarks that will prevent a modification to a contract from resulting in a taxable exchange.

Specifically, if the approved benchmarks are satisfied in the LIBOR transition, changes in contracts will not be considered taxable exchanges under the applicable Treasury regulations. Such approved benchmarks include Daily Simple SOFR, 30-Day Average SOFR and Term SOFR.

Practical Impacts

Although avoiding a tax event may appear to be beneficial, taxpayers may suffer economic losses due to the LIBOR transition, which may not be reflected in an immediate deduction for income tax purposes.

We note that the recommended benchmark spread adjustments related to the approved new benchmarks do not necessarily reflect the true economic spread between LIBOR and the new benchmarks. For example, the benchmark spread adjustment for 1-month LIBOR has commonly been established as 10 basis points, although the effective economic difference between 1-month LIBOR and 1-month SOFR-based rates has fluctuated on a daily basis, sometimes at a much higher or much lower spread than the standard 10 basis points adopted by market participants.^[1]

Recent Actual Benchmark Rates

Set forth below are sample dates reflecting 1-Month USD LIBOR and 1-Month USD Term SOFR during each quarter in 2022 and 2023, including a typical 10-basis point spread adjustment, with new effective rates:

Utilizing a different benchmark replacement, such as 30-Day Average SOFR, can lead to even wider variations. For example, on October 24, 2022, the differential between 1-Month USD LIBOR and USD 30-Day Average SOFR, after taking into account the benchmark spread adjustment, was -46 basis points (1-Month LIBOR of 3.58% and 30-Day Average SOFR of 3.02% with a +10 basis point spread). Accordingly, a borrower would benefit from a change from 1-Month USD LIBOR to USD 30-Day Average SOFR by 46 basis points.

Financial Ramifications

The following examples assume a non-amortizing loan with $100 million principal outstanding and a 5-year remaining term, with an annual interest rate of 1-Month USD LIBOR plus a 3% borrower credit spread:

Example 1

If the borrower and the bank entered into LIBOR transition amendments to change the 1-Month USD LIBOR term to 1-Month USD Term SOFR and the transition was effective on June 21, 2022, the new effective interest rate as of the transition date would have been 4.60% (1.50% 1-Month USD Term SOFR plus a benchmark adjustment spread of 10 basis points plus a 3% borrower credit spread). If, however, the loan had continued to be based on 1-Month USD LIBOR, the effective interest rate would be 4.64% (1.64% 1-Month USD LIBOR plus a 3% borrower credit spread). If interest rate spreads remained constant throughout the remainder of the loan, economically, the bank would have a negative differential of 4 basis points or an economic loss of $200,000 during the remaining term of the loan (0.04%, annually, applied to $100,000,000 of principal, over a 5-year period) while the borrower would have a parallel positive differential and a $200,000 economic gain through loan maturity.

Under the final Treasury regulations, the transition amendments qualify as a covered modification of the loan, because 1-Month USD Term SOFR is a qualified rate. Therefore, the effectuation of the transition is not treated as an exchange of property under applicable Treasury regulations and does not result in taxable income or loss to either party. The bank is not permitted to presently deduct the $200,000 economic loss (although the bank will recognize less interest income over the life of the loan), while the borrower avoids taxation on the $200,000 economic gain (although the borrower will have a lower interest cost over the life of the loan in an equivalent amount to the bank’s lost interest income, assuming interest rate spreads remain constant).

Example 2

Conversely, if the borrower and the bank entered into the same LIBOR transition amendments as Example 1, but the transition was effective on March 6, 2023, the new effective interest rate as of the transition date would have been 7.82% (4.72% 1-Month USD Term SOFR plus a benchmark adjustment spread of 10 basis points plus a 3% borrower credit spread) while the interest rate without the transition would be 7.71% (4.71% 1-Month USD LIBOR plus a 3% borrower credit spread). The bank would have a positive differential of 11 basis points or an economic gain of $550,000 during the remaining term of the loan (0.11%, annually, applied to $100,000,000 of principal, over a 5-year period) while the borrower would have a parallel negative differential and a $550,000 economic loss through loan maturity, in each case assuming interest rate spreads remain constant.

 Again, the effectuation of the transition would not trigger an exchange of property and would not result in taxable income or loss to either party because 1-Month USD Term SOFR is a qualified rate. The bank would avoid being presently taxed on the economic gain (although such gain may be recognized over the term of the loan as a result of increased interest income) and the borrower would be disallowed from presently deducting the $550,000 economic loss (which amount would be reflected in higher interest costs over the life of the loan).

Example 3

Finally, if a borrower entered into the same LIBOR transition amendments as Example 1, but the Term SOFR transition was implemented not to become effective until LIBOR’s end date – June 30, 2023, which will likely be the case, there is currently no way to determine the economic ramifications of the LIBOR transition to either the bank or the borrower until the future LIBOR end date. The financial ramifications of the LIBOR transition will then not be reflected until 2023 tax reporting and financial statement auditing is completed in 2024.

Special Swap Considerations

Finally, we note that there may also be divergent tax treatment of integrated or associated swaps not modified into a parallel SOFR-based instrument, including swaps modified under the ISDA Protocol with Daily Simple SOFR as the replacement benchmark as well as unmodified swaps that still utilize LIBOR.

Conclusion

Though utilizing the new Treasury regulations may avoid a tax event, it may cause a financial gain or loss. The financial ramifications should be appropriately addressed and handled during the 2023 and 2024 tax and annual audit tax seasons.

Best of luck this tax and annual audit season…

FOOTNOTES

^[1] The official benchmark spread adjustment for 1-Month LIBOR, established in March 2021, is 11.448 basis points.

^[2] In our experience, borrowers often prefer to utilize 30-Day Average SOFR or Daily Simple SOFR (which are actual interest rates), rather than Term SOFR (which is a derivatives-based rate)