The transition from the London Interbank Offered Rate (LIBOR) is underway. On December 31, 2021, the publication of the one-week and two-month USD LIBOR ceased. While other rates on the index will continue to be published through June 30, 2023, affected financial institutions should:
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The Secured Overnight Financing Rate (SOFR) is one rate replacement option and the most common LIBOR replacement for U.S. financial institutions. SOFR is referenced as a qualified rate in Treasury regulations (but not the only rate). The SOFR, published by the Federal Reserve Bank of New York, is a measure based on the cost of banks’ overnight cash borrowing collateralized by Treasury bond repurchase agreements (“repos”). The SOFR is a daily weighted average of repo transaction rates and believed to be a more accurate and secure index than LIBOR because it is based on the actual rate that large financial institutions pay each other.
A transition to SOFR can provide certain tax benefits. Generally, under Internal Revenue Code (IRC) Section 1001 and the accompanying Treasury regulations, a yield modification of this type could be considered significant, resulting in taxable gain or loss. Yet, Treasury Regulation 1.1001-6, finalized on January 4, 2022, specifically allows for certain debt modifications (called “covered modifications”) related to using a new qualified rate (instead of LIBOR) to be nontaxable. Revenue Procedure 2020-44 originally set a December 31, 2022 deadline. The final regulations, however, eliminated this deadline, making the tax treatment of covered modifications permanent.
The final regulations define a covered modification to be when contractual terms are modified to replace a discontinued Interbank Offered Rate (IBOR) with a qualified rate (e.g., SOFR). Conversely, if the exchange or any part of the exchange does not qualify as a covered modification, it is deemed a noncovered modification possibly resulting in gain or loss under IRC Section 1001. A noncovered modification could include changes to the amount or timing of contractual cash flows identified in the original contract.
Treasury Regulation 1.1001-6 became effective on March 7, 2022. For covered modifications completed prior to this date, the regulations allow taxpayers to rely upon the final regulations if they consistently apply the final regulations to all LIBOR contract modifications prior to March 7, 2022.
In a joint statement released in November 2020, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation encouraged banks to carefully plan for an orderly transition from LIBOR. The statement encouraged banks to stop using LIBOR after December 31, 2021, for new contracts, to mitigate safety and soundness risks, warning that the use of LIBOR for new contracts in 2022 would lead to an examination of bank practices. As detailed in the statement, the three agencies do not recommend a particular rate, but provide guidance encouraging banks to determine a rate that is appropriate for its funding model and customer needs.
The transition away from LIBOR presents a material shift in systems requiring significant planning. At a minimum, financial institutions should be using SOFR or another qualified rate for all new financial contracts. Best practice may also involve modifying existing contracts now even though LIBOR rates will be published through June 30, 2023.
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