LIBOR (London Interbank Offered Rate) is a set of interest rate benchmarks based on the rates at which banks were willing to borrow unsecured funds in the interbank market. It has been used in numerous financial instruments such as loans, derivatives and other financial products, as well as leases. For more than a decade regulatory actions have been underway to reform benchmark rates and ultimately replace LIBOR as the benchmark interbank borrowing rate. In March 2021, the Financial Conduct Authority (FCA) and the ICE Benchmark Administration, the administrator of LIBOR, announced that sterling, euro, Swiss franc and Japanese yen LIBOR panels, as well as panels for one-week and two-month US dollar LIBOR, would cease at the end of 2021, with the remaining US dollar LIBOR panels ceasing at the end of June 2023. The announcement reiterated to market participants the need to prepare for and complete the transition from LIBOR, in some cases by the end of 2021.
There are currently a wide range of debt instruments and other financial products that reference LIBOR. Thus, although LIBOR was available until at least the end of 2021, market participants have been planning for the transition. It should be noted that while many of the LIBOR tenors ceased to be published after 2021, some of the most widely used US dollar LIBOR tenors will continue to be published until at least the end of June 2023. Modifications of both contractual fallback provisions as well as actual rates referenced in existing debt instruments and other financial products are expected in many cases. In doing so, parties should be aware of the tax implications.
Tax Issues and Administrative Guidance by Jurisdiction
This note discusses the transition from LIBOR from a multijurisdictional perspective. Included in this note is an analysis of the general rules and considerations of modifications and similar actions required to transition from LIBOR and accompanying tax implications with respect to the United States (including discussion of the new IRS rules released December 30, 2021), The Netherlands, Mexico, Spain, Italy, Luxembourg, France and Germany. What is clear is that across each of the jurisdictions, the test of whether tax implications are likely to occur as a result of the transition is a facts and circumstances inquiry. Careful consideration should be undertaken with respect to modifications or similar acts implementing the transition from LIBOR. While many have already begun implementing the transition from LIBOR, others are still in the transition process. We expect that 2022 will be a critical year for many working to complete their integration and transition from LIBOR. Taxpayers should consult their tax advisors and counsel regarding how the rules described herein may apply to particular agreements.
Under regulations issued under US Internal Revenue Code section 1001, gain or loss is realized upon the exchange of property differing materially in kind or extent. Specifically, for debt instruments, section 1.1001-3 of the US Treasury Regulations provides rules intended to measure whether modifications are economically significant, which in turn, would result in deemed debt-for-debt exchanges for US federal income tax purposes. For non-debt instruments, similar concepts apply under the fundamental change doctrine.
There are a variety of US tax consequences that can result from a deemed exchange resulting from the modification of a debt instrument. A deemed exchange could result in the debt holder having capital or ordinary gain or loss, while the debt issuer may have corresponding ordinary interest expense (i.e., repurchase premium) or ordinary income (i.e., cancellation of debt income). If a hedged debt instrument is significantly modified due to a change in LIBOR, its deemed termination may cause a corresponding gain or loss with respect to the hedge itself. Similarly, changes to a reference rate used in an integrated hedge may cause the debt instrument and derivative to be separated and prevent the taxpayer from re-establishing the integrated hedge treatment for 30 days. A deemed exchange could also potentially affect the US tax status of certain types of special purpose securitization vehicles holding the modified instrument, as well as the grandfathered status of the modified debt instrument under the Foreign Account Tax Compliance Act (FATCA).
In late 2019, the US Internal Revenue Service (IRS) issued proposed regulations addressing whether a change that replaces LIBOR with a replacement, and other associated alterations, will trigger a deemed exchange. The IRS issued subsequent guidance in 2020 providing that the addition of model fallback language recommended by Alternative Reference Rates Committee (ARRC) and International Swaps and Derivatives Association (ISDA) to an existing debt instrument would not result in a deemed exchange for US tax purposes. On December 30, 2021, the IRS released final regulations (Final Regulations) providing guidance on the tax consequences related to the transition away from LIBOR to different reference rates in debt instruments and financial contracts.
The Final Regulations provide that a modification of a contract that is a “covered modification” is not treated as a deemed exchange. A covered modification generally has four elements: (i) a contract with an operative rate or fallback provision that references a discontinued LIBOR rate; (ii) a “modification” of that contract (a) to replace an operative discontinued LIBOR rate with a “qualified rate” or to add an obligation for one party to make a “qualified one-time payment” (if any), (b) to include a qualified rate as a fallback to an operative rate that refers to a discontinued LIBOR rate, or (c) to replace a fallback rate that refers to a discontinued LIBOR with a qualified rate; (iii) certain “associated modifications” with respect to those modifications of the operative rate or fallback provisions; and (d) the modification is not an “excluded modification.” A “qualified rate” is a rate that is listed as eligible to be a qualified rate (such as the Secured Overnight Financing Rate, or SOFR), provided that the interest rate benchmark to which the rate refers and the discontinued LIBOR rate are based on transactions conducted in the same currency or are otherwise reasonably expected to measure contemporaneous variations in the cost of newly borrowed funds in the same currency.
A modification generally is an “excluded modification” if it changes the amount or timing of contractual cash flows and is (i) intended to induce one or more parties to perform any act necessary to consent to the modification, (ii) intended to compensate one or more parties for a modification other than a covered modification, (iii) either a concession granted to a party to the contract because that party is experiencing financial difficulty or a concession secured by a party to the contract to account for the credit deterioration of another party to the contract, (iv) intended to compensate one or more parties for a change in rights or obligations that are not derived from the contract being modified, or (v) is identified by IRS guidance as having a principal purpose of achieving a result that is unreasonable in light of the purpose of the Final Regulations.
This IRS guidance should be carefully considered in implementing any modifications to the terms of debt or other financial instruments relating to the transition from LIBOR.
A modification of contractual fallback provisions and actual rates referenced in existing debt instruments and other financial products could, under certain circumstances, lead to a taxable event for Dutch income tax purposes. This would have to be reviewed in line with the tax principle of sound business practice (goed koopmansgebruik) as established under Dutch case law. Upon occurrence of a taxable event the difference in fair market value and the tax book value of the debt instrument or financial product may, depending on the nature of the holder of the existing debt instrument or financial product, need to be reported for Dutch income tax purposes. The differences between the likely tax position of various types of holders of debt instruments is beyond the scope of this note.
For Dutch income tax purposes, the modification of an existing debt instrument that is considered to be a repurchase, reissuance, novation or (deemed) exchange of the instrument will result in a taxable gain or loss. An increase or decrease in the value or a change in credit risk of such a debt instrument are important elements to assess the tax consequences of a modification of the instrument. A change in value may in particular be recognised where, depending on the nature of the holder of the debt instruments, the debt instruments have been depreciated or written down by the relevant holder for Dutch tax purposes prior to the modification under the Dutch tax principle of sound business practice.
In case of a replacement of existing debt instruments by new debt instruments that would result in a gain or loss, specific Dutch case law regarding the exchange of assets (ruilarresten) could under circumstances apply. According to this Dutch case law, in short, there can be circumstances under which no realization of gain or loss should be taken into account by a Dutch taxpayer if an asset is replaced by another asset of an entirely similar nature that takes the same place in the business assets of such taxpayer. Moreover, in the case of securities, at a minimum it would be required from an economic perspective (i.e. substance over form approach) that the new securities take the same place in the securities portfolio of the Dutch tax payer as the securities that are being replaced. Under such circumstances, it might be possible to argue that the replacement of the existing debt instruments by the new debt instruments would not lead to taxation of the difference between the historic book value and fair market value for Dutch income tax purposes (i.e. a deferral). An important element would be that the terms, conditions, value and credit risk of the debt instruments are not impacted by the modification. The application of this case law requires a factual analysis of the relevant assets.
In summary, whether or not the transition from LIBOR triggers a taxable event (and an actual amount of tax payable) is determined on a case-by-case basis.
For Mexican tax purposes, modifications to existing agreements relating to the transition from LIBOR with regard to contractual fallback provisions and actual rates referenced in existing debt instruments and other financial products could, under certain circumstances, lead to a taxable event.
Whether there is a taxable event will depend on the nature of the debt instrument or financial product and the holder of such instrument or product. If there is a taxable event, the difference in the reference value and the acquisition value of the debt instrument or financial product must be reported for Mexican income tax purposes.
A taxable event may occur for Mexican income tax purposes if there is a modification of an existing debt instrument that is considered to be a repurchase, reissuance, novation or exchange that results in a gain or loss.
The determination of whether taxpayers are obliged to report the difference in value as taxable income will be on a case by case basis, based on whether (i) the modification corresponds to a cash liquidation of the difference in value (repurchase), (ii) the instrument is traded for another title with different characteristics (reissuance or exchange), or (iii) there is a substantial change in credit risk of the debt instrument that can be regarded as an important element to assessing whether it is considered as a modification of the instrument (novation).
In this regard, the modification with respect to LIBOR transition could trigger a taxable event for Mexican taxpayers, depending on how the classification of the modification is considered from a Mexican legal and tax standpoint.
Under Mexican tax rules applicable to individuals, any gain realized on the disposal of debt instruments or financial product is subject to capital gain tax, at a progressive tax rate up to 35%, when such instrument or product is liquidated in any form. The same applies to legal entities, at a 30% corporate tax rate, with respect to any gains on the liquidation of the instrument or product.
It will be necessary to analyze on a case by case basis whether modifications of debt instruments and other financial agreements relating to transition from LIBOR will result in a taxable event for Mexican income tax purposes and, if it does, whether there is an actual payable tax for such transition.
Spanish tax consequences derived from the modification of LIBOR as the applicable benchmark rate may be analyzed both from the direct taxation (income taxes) and indirect taxation (VAT/stamp duty) perspectives. However, please note that, so far, the Spanish Tax Authorities have not issued any guidance or tax rulings regarding the tax implications derived from the LIBOR modification.
The modification of the interest rate by changing the reference rate and the differential to be added to it may qualify as a novation of the loan. In those cases where the loan is secured by a mortgage, if the novation is entered into a public deed (escritura pública) the first copy of such public deed may initially be subject to Stamp Duty if certain requirements are met: as mentioned, it should be entered into a public deed, such deed should be recordable in an Spanish public registry and also the modification/novation should have a valuable content.
However, in those cases where the modification/novation (i) does not have a valuable content or (ii) is not entered into a public deed (escritura pública), Spanish Stamp Duty does not accrue. Moreover, please note that an specific Stamp Duty exemption applies when: (i) the transaction is formalized into a public deed mutually agreed between the lender and the borrower, (ii) the lender is one of the qualified entities referred to in article 1 of Law 2/1994 (i.e. Spanish financial institution) and (iii) the modification refers to the conditions of the interest rate, initially agreed or in force, to the alteration of the term of the loan or to both of them.
Unsecured loans are exempt from VAT (as secured loans) an are not subject to Transfer Tax/Stamp Duty, Hence, the LIBOR transition should not have any Transfer Tax/Stamp Duty impact upon those transactions.
From a direct taxation perspective, the consequences of the modification of the interest benchmark should be reviewed in a case by case basis. A mere modification of the interest rate of a loan entered between related parties could affect the arm’s length valuation of such transaction and may have Spanish transfer pricing implications.
Also, please note that the modification of the interest benchmark could also have impact on the deductible amount of interest expenses for Spanish CIT purposes. In this regard, please note that pursuant to the Spanish CIT Law, net financial expenses are deductible with the annual limit of the higher of 30% of the EBITDA of the tax period or the amount of €1 million. However, interest exceeding the 30% EBITDA or €1 million threshold can be carried forward and deducted, subject to the same limits, in the following years without time limit.
For Italian tax purposes, modifications to existing debt instruments or other financial agreements relating to the transition from the currently applicable LIBOR to new substitute benchmarks may or may not trigger a taxable event for the relevant securities holders depending on the factual circumstances applicable to each security.
In general terms, any form of transfer of ownership for consideration of a security (including the mere sale versus consideration, the contribution versus shares/other assets, the exchange of one security versus another security (permuta), any other transaction producing the same effect) triggers the realization of any underlying capital gain or loss, which is generally taxable at 26% (except in case of corporate entities which normally include such capital gain/loss in their business income and subject it to corporate income tax at 24% and in case of investment funds which are normally exempt from income taxes, which are instead applicable upon subsequent distribution to unitholders).
Following the above, the key point is whether modifications relating to the replacement of LIBOR with new benchmarks can be characterized as giving rise to a deemed exchange (permuta) of the existing security (linked to LIBOR) with new securities (linked to a new benchmark) and thus may give rise to the realization of the underlying capital gains/losses taxable in the hands of the securities holders.
Based on Italian civil and tax law principles, on the one hand, the contemplated replacement of LIBOR could be characterized as a deemed disposal or exchange of the original security if such replacement implies a novation of the original security, i.e. provided that the original security is extinguished (e.g. through early repayment or redemption) and a new security is issued by the relevant issuer (i.e. with new ISIN number). In such a case the existing asset would be replaced by/exchanged with the new asset at the level of the Italian security holders, with the consequence that any underlying gain/loss should be recognized and taxed in the hands of such Italian security holders;
On the other hand, the replacement of LIBOR may not be characterized as a deemed disposal or exchange of the original security if such replacement merely implies an amendment of the remuneration linked to the instrument, but which (i) does not affect the other terms and conditions of the existing instrument, (ii) does not trigger the early repayment/redemption of the original security and the issuance of a new security, (iii) does not trigger the amendment of the original ISIN number, (iv) is not characterized as a form of novation of the instrument by the parties (issuer and security holders). If such conditions are met, based on the contractual documentation of the security (e.g. prospectus, subscription agreement, etc.), the replacement of the LIBOR with new benchmarks should not by itself trigger any tax consequences at the level of the Italian security holders.
As described, it is critical to consider the individual facts and circumstances of each security on a case-by-case basis.
The transition from the currently applicable LIBOR to new substitute benchmarks also may or may not trigger tax consequences in respect of loan agreements and other contractual arrangements linked to LIBOR, depending on the relevant factual and contractual circumstances. The analysis is based, both for the loan agreement and for securities, on how the replacement is designed under the specific contractual arrangement.
In case of loan agreements the analysis shall address whether the amendment qualifies under a civil law perspective as a novation (i.e. as the parties willingly replacing the original contractual arrangement with a new one, e.g. with provisions as to the formal draw down of the new loan and use of such moneys to repay the original loan, release of the existing guarantees and granting of new guarantees, etc.), whilst in the case of securities the analysis shall focus on whether the amendment gives rise to the exchange of one security versus another security (permuta).
In other words, in both cases the focus is on whether the amendment implies the replacement of an existing relationship with a new one, but the elements to be evaluated are tailored to the specific instrument.
If the replacement of the LIBOR can be deemed to produce a novation of the contractual arrangement resulting in the replacement of the existing loan agreement with a new loan agreement (which is drawn down to extinguish the existing loan), whilst no income tax effects will arise in the hands of either the lender or the borrower, the novation will instead trigger new Italian documentary tax liabilities for both of the parties (although the relevant burden is normally allocated contractually on the borrower). More specifically, the new loan will be subject to Italian documentary tax irrespective of whether documentary taxes had already been paid on the existing loan. This effect can be particularly significant for secured loans involving Italian notarial security documents such as mortgages on Italian real estate properties, pledges on Italian S.r.l. stock, Italian special liens or assignments of receivables vis-à-vis Italian public authorities (e.g. VAT receivables). Depending on the nature and characteristics of the loan agreement and of the related security package, the documentary tax may range from sole liability to a 0.25% substitutive tax on the amount of the facility (which replaces any and all other forms of documentary taxation) to a variety of documentary taxes such as registration tax at up to 0.5% on the secured amount and mortgage tax at 2% on the secured amount.
On the contrary, if the replacement of the LIBOR cannot be deemed to produce a novation of the contractual arrangement so that the existing loan agreement continues to remain valid and binding with the sole replacement of LIBOR with new benchmarks, no income tax or proportional documentary tax liability should be triggered.
Under article 22 (5) of the Luxembourg income tax law, an exchange of instruments is considered, for tax purposes, as a taxable sale followed by the acquisition by the disposing holder. The sale price of the asset given in exchange should be considered – for Luxembourg tax purposes – to be its fair market value. As a consequence, in case of an increase in value, any gains realized upon such exchange may be taxable at the level of a Luxembourg security holder subject to Luxembourg income taxes. However, for such gain to become taxable, a genuine exchange must occur from a Luxembourg tax perspective whereby one instrument is given in exchange (including reissuance, novation or alike) for another; as such, there should be some distinctive and significant differences between the two instruments for article 22 (5) to be triggered. Important to keep in mind in this respect is that Luxembourg applies the so-called substance over form principle according to which the tax qualification is not automatically bound by the legal form of a transaction, which must be treated according to its fundamental economic nature.
Modifications of both contractual fallback provisions as well as actual rates referenced in existing debt instruments and other financial products need thus to be analyzed on a case-by-case basis to assess whether this could lead to a (deemed) exchange for Luxembourg tax purposes, triggering thus article 22 (5). Further, some other tax consequences may result from the modification of a debt instrument depending of its significance; for instance, adverse tax consequences may not only be triggered at security holder but also issuer level (in the form of either an additional expense or income) if the degree of the amendment could result in a deemed substitution or termination of the instrument.
The tax implications arising from the modification of, inter alia, contractual fallback provisions and actual rates referenced in existing debt instruments and other financial products should be reviewed on a case-by-case basis, at the level of both the French security issuer and the French security holder.
Broadly, the contemplated modifications should not trigger any particular tax consequences at the level of the French security issuer, unless the replacement of the LIBOR with new benchmarks can be viewed as leading to a deemed exchange or disposal of the existing security (LIBOR-linked) with another security (linked to another benchmark). This could notably be the case if the scope of the modifications made to the terms and conditions of the original instrument is such that it amounts to a novation, i.e., the extinguishment of the original security and the issuance of a new security. In such instance, a taxable gain or loss would have to be recognized at the level of the security holder.
With respect to the French security issuer, the same principle should apply: if a debt instrument is significantly updated, this could result in a deemed substitution or termination of the instrument and thus give rise to additional taxable income at the level of the issuer. Otherwise, if the changes brought to the instrument/ security amount to a mere amendment of the benchmark rate, without affecting the main terms and conditions such as the early repayment/ redemption, no tax consequences should arise for the security issuer.
In any event, no stamp duties or transfer taxes would be triggered in France as a result of any amendment (however significant) to the terms and conditions of debt instruments/ securities (unless such amended agreement is voluntarily registered with the French tax authorities, in which case a €125 fee is due).
A sale or a deemed sale that leads to a transfer of the legal or at least the economic ownership of a security, including an exchange of securities, is subject to German taxation for a German tax resident security holder if it leads to a capital gain (or capital loss).
The decisive question in this matter is whether modifications relating to the replacement of LIBOR with new benchmarks can be characterized as giving rise to a deemed exchange of the existing security (linked to LIBOR) against a new security (linked to a new benchmark) for German tax purposes.
A security is characterized, among other things, by the risks associated with it. On this basis, any deviating credit risks may justify the assumption that the old security has been sold and a new one acquired. A modification of the actual benchmark referenced in existing debt instruments and other financial products needs to be analyzed on a case-by-case basis to assess whether this could lead to a (deemed) exchange for German tax purposes.
In this context it also has to be taken into account whether or not a new ISIN will be allocated to the securities in question. For example the exchange offer by the Republic of Greece in 2012 where (German) security holders had been offered new securities in exchange of the existing securities issued by the Republic of Greece was treated by the German tax authorities as a taxable exchange of securities (cf. decree of the German Federal Ministry of Finance dated 9 March 2012).
If, however, from both a legal and an economic point of view the original security remains in place, there should be no room for an exchange or a deemed exchange of the security so that there should be no realization of profits or losses under German tax laws.
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Authored by Alexander Fortuin, Juan Garicano, Heiko Gemmel, Xenia Legendre, Scott Lilienthal, Gerard Neiens, Serena Pietrosanti, and Arturo Tiburcio.