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IBOR Transition Update: The Fair Market Value Test

In October, Treasury and the IRS issued proposed regulations confirming that switching from a LIBOR-based rate to a SOFR-based rate in a debt instrument or derivative generally will not be a taxable event if the fair market value of the modified contract is substantially equivalent to the fair market value of the unmodified contract (the FMV test). We discuss the proposed regulations in greater detail here.

In the weeks since, bar associations and trade groups have expressed concern that the FMV test could create uncertainty in several contexts.

FMV Test Safe Harbors

As a general rule, fair market value must be determined using a reasonable, consistently applied valuation method and must take into account the value of any one-time payment that is made in connection with a reference rate switch.

The proposed regulations include two safe harbors for determining fair market value:

  • Historical Average. The historical average safe harbor is satisfied if, on the modification date, the historical average of the replacement rate (adjusted to account for any one-time payment made in connection with the modification) is no more than 25 basis points from the historical average of the IBOR-based rate. A historical average may be determined by using an industry-wide standard or a continuous look-back of up to 10 years.
  • Arm’s-Length. The arm’s-length safe harbor is satisfied if the parties are unrelated and determine, based on bona fide, arm’s-length negotiations, that the fair market value of the modified instrument is substantially equivalent to the fair market value of the unmodified instrument.

Taxpayer Concerns

As the phase-out of LIBOR and corresponding phase-in of SOFR could impact the fair market values of instruments that reference these rates, taxpayers may have difficulty administering the FMV test if neither of the safe harbors is available. Because failing the FMV test could result in material adverse tax consequences, taxpayers will prefer to satisfy a safe harbor.

However, the safe harbors do not clearly accommodate the selection of a replacement rate by a third party:

  • Determinations by a Trustee or Calculation Agent. Many debt issuances and derivative contracts allow a trustee or calculation agent to determine a replacement rate. For administrative reasons, the new rate might not clearly satisfy the historical average safe harbor (e.g., because it does not use a 10-year look-back, or because the look-back ends on a date other than the modification date). Moreover, it is unclear whether the trustee or calculation agent would be a "party" for purposes of the arm's-length safe harbor, or whether its selection of a new rate could be considered arm's-length negotiations.
  • ISDA Protocol. We understand that ISDA intends to issue a protocol whereby, upon the occurrence of a "trigger event" (e.g., the cessation of LIBOR), adhering parties will be deemed to have adopted a replacement rate published by Bloomberg Index Services Limited. The protocol may not satisfy the historical average safe harbor because Bloomberg will use a historical period ending on the day before the trigger event date (and not the modification date), and may not satisfy the arm's-length safe harbor because the protocol is designed so that the parties do not negotiate directly.
  • Legislative Approach. ARRC has announced that it is exploring potential legislation that, in certain circumstances, could require parties to adopt a LIBOR fallback rate published by a governmental authority. Again, it is unclear whether any such legislative approach would satisfy the safe harbors.

We anticipate that taxpayers will raise additional concerns as market participants continue to consider how to deal with LIBOR's impending demise. 

Key Contacts

Adam Blakemore
T. +44 (0) 20 7170 8697

Linda Z. Swartz
T. +1 212 504 6062

Jon Brose
T. +1 212 504 6376

Andrew Carlon
T. +1 212 504 6378

Mark P. Howe
T. +1 202 862 2236

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