Treasury Releases Guidance on the Transition from Interbank Offer Rates to Other Reference Rates with Respect to the Interest Rates of a Foreign Bank

On June 30, 2023, the United States Department of the Treasury (“Treasury”) published Final Regulations as guidance on the transition from the use of the Interbank Offer Rate (IBOR) to the Secured Overnight Financing Rate (SOFR).¹

Background

IBOR, also referred to as the London Interbank Offer Rate (LIBOR), is an interest rate benchmark used in financial contracts. Between 2017 and 2021, the regulators in charge of overseeing IBOR announced that they would cease to publish the currency and term variants, and the overnight, one-month, three-month, six-month, and twelve-month IBOR, with the final date of publication being on June 30, 2023. Bankers and regulators in the United States then set out to find a suitable replacement to IBOR, and the recommendation was to adopt SOFR.

Initial Regulations

In conjunction with the announced discontinuation of IBOR, Treasury released regulations in 2022 (the “Initial Regulations”) to give guidance addressing the possibility that taxpayers who needed to modify the terms of a contract to replace IBOR with another published rate could be considered a realization event, and therefore give rise to income or deduction.² For example, the Regulations state that if property is exchanged for property differing materially in kind or extent, there will be a realization event under section 1001 of the Code.³

In response to such concerns, Treasury released the Initial Regulations ruling that a contract modification replacing IBOR with another published rate would not be a realization event, so long as the modification is a covered modification, as that term is defined by the Regulations.⁴

The Proposed Regulations

In preparation for the transition from IBOR to SOFR, Treasury released proposed regulations in 2019 (the “Proposed Regulations”).⁵ An issue arising from the transition from IBOR to SOFR was the ability for a foreign corporation, that is a bank, to elect to use the published average 30-day LIBOR to calculate the interest expense allocable to its income effectively connected (ECI) to a U.S. trade of business.⁶ The Proposed Regulations include a provision that allows such a foreign corporation to use the yearly average SOFR. Because using the yearly annual SOFR would result in a lower rate than under previous law, Treasury requested comment on the Proposed Regulations.

Final Regulations

Based on the single comment received, Treasury released Final Regulations adopting SOFR, and incorporating the comment which recommended using the one-month term SOFR, but adding a static spread adjustment of 0.11448%. This would close the potential gap between the DOFR and IBOR, while still allowing taxpayers to use a published rate to calculate their U.S.-based liabilities, instead of the actual rate, which is often data that is not based in the United States and may be harder to obtain.

One additional change made in the Final Regulations applies in cases where the taxpayer failed to properly account for the interest from excess ECI. Under the previous regulations, the IRS is allowed to use either the taxpayer’s actual rate or the published rate to calculate the taxpayer’s tax liability.⁷ The Final Regulations amend this provision and requires the IRS to use the published rate in conducting its examination, thereby reducing the burden of calculation on both the IRS and the taxpayer.⁸

The Final Regulations are applicable to all taxable years ending after June 30, 2023. For taxable years that straddle the periods under which IBOR and SOF are applicable, the taxpayer must calculate a blended published rate using IBOR for the periods of the taxable year on or before June 30, 2023, and SOFR for portions of the taxable year on and after July 1, 2023.