The End of Libor – Proposed Helpful Guidance for Borrowers from the Treasury Department for Tax Exempt Bond Obligors – With Some ‘Buts’
Many of these transactions have been synthetically “fixed” by the conduit borrower entering into an ISDA interest rate swap transaction in which the borrower pays a fixed rate times a “notional amount” typically designed to mirror the principal balance of its bond debt over the life of the swap, and receives back a payment based on LIBOR intended to economically match its original bond debt interest obligations. For a variety of reasons, as has been widely reported, LIBOR is to cease to be published by the end of 2021 and this expected elimination of the index upon which many tax exempt bond transactions are based raises serious tax and non-tax concerns.
The Treasury Department has issued Proposed Regulations that outline a number of options which, if used by borrowers and their bondholders (typically a bank or bank affiliate in a direct purchase transaction or public bond market investors in a publicly offered/private placement transaction) and/or if used by borrowers and their swap counterparties (typically, when a bank holds the bonds, the same bank) will allow both the borrowers and their lenders/swap providers to avoid some adverse tax consequences when LIBOR ceases to be available. The potentially adverse tax consequences that the Proposed Regulation would allow parties to avoid arise if a transaction (whether a bond or swap) is modified in such a way that it would otherwise be treated for tax purposes as though the pre-existing contract was cancelled and a new contract was entered into—known as a reissuance. A reissuance would, in most cases, result in increased reporting obligations for conduit revenue bond borrowers; however for bondholders and swap counterparties, a reissuance can result in a capital gains tax liability for bondholders/swap counterparties, the cost of which would be expected to be passed along to the borrowers.
To avoid these problems, Treasury has said that if the parties to these sorts of agreements substitute any one of many specifically identified replacement indexes, including the Secured Overnight Financing Rate (SOFR) published by the Federal Reserve Bank of New York, a reissuance does not occur. (Several other options for establishing alternate rates are also provided for in the Proposed Regulation.) Similarly, if, in connection with a change in rates to an accepted alternative rate, a lump sum payment is made by one party to the other in certain circumstances, and if that payment results in the value of the pre-modification contract (the bond or swap) and the post-modification contract being substantially equivalent, there also is no reissuance. So far so good (at least from a tax perspective), in particular because it is expected that these lump sum payments, if required, would come from the borrowers. In fact, under the Proposed Regulation if a lump sum payment of this sort is with respect to an alteration to a bond (not a swap), the payment itself would be tax exempt, again reducing the potential cost to borrowers.
Although the foregoing is helpful guidance, there are always some “buts” and while some may be addressed when the Proposed Regulation is finalized, some cannot be addressed by regulation.
First, what if a borrower has a variable rate (LIBOR based) bond obligation and an offsetting (LIBOR based) swap as outlined above, but the bondholders and swap counterparty (whether related entities or not) do not agree to amend their respective contracts to adopt the same alternative index? In that case, although the Proposed Regulation appears to allow the parties to treat the two contracts as still “integrated” for tax purposes (i.e., the bond will still be treated as fixed rate for tax purposes), this potential mismatch of indexes would leave the borrower in a situation where it used to have its variable rate debt effectively fully converted into a fixed rate obligation but now finds itself in a situation in which it remains exposed to the difference between the two indexes if different indexes are adopted by the bondholders and swap counterparties. This is not a problem that can be fixed by regulation.
Similarly, what if one of the parties to a transaction (the bondholders or swap counterparty, or even the conduit borrower) refuses to agree to an alternative index? Most older documents were drafted in a setting where the elimination of LIBOR was unimagined, and the documents will not address this—is it a default? Is it a swap Termination Event and if it is, who is the “Affected Party” (in ISDA parlance)? This, too, cannot be addressed by regulation (and cannot be addressed effectively by ISDA since it cannot retroactively alter swap contracts already in existence). And what about publicly traded floating rate bonds—how will Bond Trustees (in the absence of 100% bondholder consent) chose a replacement index? Again, a problem that cannot be solved by regulation.
The Proposed Regulation does not address the implications of a lump sum payment of the type described above on yield restriction or rebate for tax exempt bonds. Since the Proposed Regulation provides that a lump sum payment is treated as from “…the same source and character that would otherwise apply to a payment made by the payor with respect to the debt instrument….modified,” if the payment is made with respect to a bond transaction, that payment would, as noted above, appear to be treated as tax exempt interest and thus logically must be taken into account in calculating yield for rebate and arbitrage yield restriction purposes. This assumption is not addressed explicitly in the Proposed Regulation and clarification of this assumption in the final Regulation might be helpful.
Finally, though SOFR, on average, has tracked LIBOR, there are a number of areas of concern including, but not limited to (i) SOFR was only created last year so there is limited historical tracking experience, (ii) there have been periods of times during the past year (i.e. quarter/year ends) when the rates have not tracked and (iii) last month, SOFR and LIBOR did not track each other for reasons that are not yet clear to the market. Selecting an appropriate alternative index, therefore, may require expert guidance.
Still, this guidance from the Treasury Department is helpful, but we will have, unfortunately, much work to do to transition LIBOR based transactions into the post-LIBOR world, and there may be costs incurred in connection with these inevitable changes to LIBOR based transactions.
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