October 09, 2019
Jason Schwartz comments on the U.S. Department of the Treasury’s proposed regulations enabling taxpayers to avoid adverse tax consequences when they modify financial instruments to reflect the global transition from interbank offered rates (IBORs) to new reference rates.
An excerpt from “Treasury Offers Safe Harbors From Taxes Due to IBOR Transition,“ Tax Notes, October 9, 2019:
According to Jason Schwartz of Cadwalader, Wickersham & Taft LLP, some parties might run into snags if the associated changes made to replace the IBOR reference rate aren’t “reasonably necessary” to implement the replacement. He noted that the proposed regs give an example of the parties increasing the interest rate to reflect a decline in the borrower’s creditworthiness.
“In that case, the regs require that you essentially bifurcate the transaction into two modifications,” Schwartz said. “One modification is to change the LIBOR rate to another rate with a substantially equivalent FMV. The second modification is to change the interest rate.”
Schwartz said there are areas in which the parties doing a bifurcation will need to be careful.
“There might be questions at the margins as to how much the interest rate has changed, what belongs to the ‘good’ modification, and how much was attributable to the decline in creditworthiness,” Schwartz said. “Whatever the parties ultimately decide could have significant bearing on their tax consequences — gain recognition, change in holding period, etc.”
The proposed regs also provide that the source and character of one-time payments made by borrowers to account for differences between the IBOR and replacement rate will have the same source and character that would otherwise apply to a payment made by the borrower regarding the debt instrument or non-debt contract that is altered or modified.
Schwartz said it isn't clear how that rule will work in some contexts.
“The regs explicitly reserve on how you treat payments by the lender to the borrower,” Schwartz said. “In the context of debt instruments, it would be more helpful if the regs explicitly provided that the payments are interest by the borrower rather than, say, a fee, which could attract withholding tax.”
For derivatives, he said some payments might be treated as a return of capital or as giving rise to a capital gain or loss. "Some payments may be treated as [fixed or determinable annual or periodic] income, which could give rise to withholding tax,” Schwartz said.
Schwartz said he hopes the final regs clarify that one-time payments don’t attract U.S. withholding tax.
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