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IRS Issues IBOR Fallback Safe Harbor for ARRC and ISDA Provisions

On October 9, 2020, the Treasury Department and the IRS issued Revenue Procedure 2020-44, which provides that a modification to a debt instrument or derivative to include fallback language published by the Alternative Reference Rates Committee (ARRC) or the International Swaps and Derivatives Association (ISDA) does not result in a deemed taxable exchange of that instrument.

The revenue procedure is helpful but narrow. Taxpayers that want certainty that a modification will not cause a taxable exchange under the revenue procedure generally will need to adhere to ARRC or ISDA fallback provisions as published, without any deviations other than those “reasonably necessary” to adopt the provisions, such as changes to the definition of interest period or to the timing and frequency of rate determinations. We understand that many taxpayers may not adhere verbatim to the ARRC or ISDA fallback provisions (for example, because they prefer to use their own shorter form language, they want to add perceived clarifications to some of the descriptions, they prefer a different rate waterfall, or they want additional features such as a later conversion to a term-SOFR, which does not yet exist). That said, taxpayers should keep in mind that, even if a modification to incorporate fallback language into their contracts is not described in the revenue procedure, it generally should not be treated as a taxable exchange if (1) the resulting change in yield is less than 25 basis points or (2) the modification satisfies the requirements of the 2019 proposed regulations.

The 1996 Regulations

A material modification of an investment generally is treated for tax purposes as a taxable exchange of the investment for a new investment. A deemed exchange could have tax consequences for both parties to the investment, as we summarized here.

Tax regulations issued in 1996 provide that changing a debt instrument’s yield is not a material modification if the modification either (1) occurs by operation of the terms of the instrument or (2) changes the instrument’s yield by no more than the greater of (x) 0.25% and (y) 5% of the unmodified yield (generally determined by comparing the pre-modification yield with the post-modification yield on the date that the instrument is modified).

In the non-debt context, there are no similar bright-line safe harbors to avoid a material modification. However, many tax practitioners believe that the change-in-yield safe harbor described above should equally apply to the floating-rate legs of derivative contracts.

The Proposed 2019 Regulations

In the face of the impending phase-out of LIBOR and other IBOR-based rates, tax practitioners expressed concern that some fallback provisions might not satisfy the safe harbor in the 1996 regulations. First, even if a fallback rate results in a modified instrument that has a similar value to the unmodified instrument, the modified instrument’s yield at the time the fallback rate is adopted might not satisfy the change-in-yield safe harbor in the 1996 regulations. Second, the 1996 regulations do not address upfront payments made in connection with the adoption of a fallback rate.

In response to these concerns, the IRS issued proposed regulations on October 8, 2019 under which, very generally, the modification of an instrument to replace an IBOR-based rate with a SOFR-based or other qualified replacement—including a one-time payment made in connection with the modification—does not give rise to a deemed exchange if (1) the fair market value of the modified instrument is substantially equivalent to the fair market value of the unmodified instrument (the FMV test), and (2) the replacement rate is based on transactions conducted in the same currency as the IBOR-based rate or is otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency as the IBOR-based rate. We discussed the proposed regulations here.

Unfortunately, the proposed regulations do not provide all taxpayers with the comfort they were hoping for.

First, the proposed regulations contain two objective safe harbors for satisfying the FMV test. Not all modifications will fall within the safe harbors, leaving taxpayers uncertain as to what constitutes “substantially equivalent” fair market value.

Second, if an existing instrument is modified to include a fallback rate, it is unclear whether the eventual activation of that fallback rate would be entitled to automatic non-exchange treatment under the proposed regulations or, instead, would need to be retested to determine whether the activation is a taxable event. In other words, as drafted, the proposed regulations could be read to imply that two testing dates may be required for a legacy transaction, first when the fallback mechanism is added and again when the fallback mechanism operates to replace an IBOR-based rate in the future.

Third, although the proposed regulations address one-time payments made in connection with a modification, they are unclear on how to determine the source and character of a one-time payment.

The Revenue Procedure

The revenue procedure generally applies to modifications entered into before January 1, 2023 that adopt any of several specifically enumerated ARRC or ISDA recommended fallback provisions. These provisions are listed in section 3 of the revenue procedure, and generally include “hard-wired” approaches that do not require further negotiation among the parties after the modifications are adopted.

Deviations from these provisions generally will cause a modification to fall outside of the revenue procedure unless those deviations are “reasonably necessary” to adopt or to implement the fallback language or “cannot under any circumstances affect the operation of the modified contract” (for example, removal of references to EURIBOR in a contract that referenced LIBOR). The revenue procedure, like the proposed regulations, fails to answer the question of how to determine the source and character of a one-time payment.

Key Contacts

Linda Z. Swartz
T. +1 212 504 6062


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

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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