Libor’s expected demise poses more than one dilemma for investors in securities backed by mortgages, auto loans, credit card receivables and other kinds of financial assets. Not only does switching to a new benchmark require unanimous consent among bondholders, which may be unrealistic, but any substitution investors do agree to could have adverse tax consequences.
These tax consequences are not necessarily limited to the recognition of income, either. More importantly, they could include the loss of the securitization trust’s special tax status and the collapse of the transaction, according to the Structured Finance Industry Group.
SFIG is concerned that uncertainty about the tax consequences may delay the modifications necessary for an orderly transition from Libor, or even stop participants from making them. So it’s asking the Treasury Department and the Internal Revenue Service for relief. In a March 28 letter, Sairah Burki, a senior director and head of ABS policy at the trade group, suggested that the agencies do this in the form of a notice, rather than a regulation or more formal pronouncement. This notice could simply state that a change from a Libor index to an alternative index would not be treated as a taxable exchange.
SFIG would also like the agencies to clarify that switching to a new benchmark would not adversely affect deals structured as real estate mortgage investment conduits, or REMICs, by causing regular interest to be treated as not having fixed terms on the REMIC’s startup day.
Debt instruments issued before 2017 did not anticipate the possibility that the London interbank offered rate might permanently cease to be published. Either the offering documents were silent on the issue or they provide for a substitute designed to address a short-term interruption. For example, many specify that the last available Libor setting be used, which would turn these floating-rate instruments into fixed-rate instruments.
Some debt instruments issued after 2017, when the U.K. Financial Conduct Authority announced an end date for Libor, do have mechanisms to establish substitute rates that are more approximate, such as the secured overnight finance rate. However, SOFR is not an ideal substitute for Libor, either. It is a nearly risk-free rate, while Libor reflects the risk of banks lending to each other. SOFR is also an overnight rate, while the most frequently used Libor rates are for one, three and six month tenors. Regulators and market participants eventually hope to establish better alternatives, which may be based on SOFR plus a spread designed to reflect some risk. So investors in securities issued more recently may also, at some point in the future, want to switch to another benchmark not anticipated in their offering documents.
The requirement for unanimous consent to switch benchmarks itself is a major hurdle, because financial assets are held “in street name” by a brokerage firm, bank or dealership, obscuring their true ownership. But even if every investor in a particular security can be identified and agrees to adopt a new benchmark, this switch could be viewed by the IRS as a “significant modification” of debt instrument, which can result in a taxable exchange of the Libor-based debt instrument for a new debt instrument under Section 1001 of the Internal Revenue Code, SFIG’s letter states. And if the “new” debt instrument has a different issue price than the “old” debt instrument, this can change the timing and amount of the accrual of discount and the amortization of premium on the debt instrument.
To add insult to injury, such a transaction could also cause a debt instrument that is otherwise grandfathered from the Foreign Account Tax Compliance Act, or FATCA, to lose that status, the letter states. Securitizations domiciled offshore fall under FATCA’s umbrella, but because the regulation was not contemplated when many older asset-backeds were issued, their legal structures leave then unable to comply with the reporting requirements. Unless grandfathered, they could be subject to a withholding tax on loan interest, principal payments and sale proceeds.
In making its case for relief, SFIG argues that lenders and borrowers in transactions switching benchmarks will, in most cases, be dealing at arm’s length. Therefore, “the potential for abuse from a Libor rate substitution (that is, as a way to change rather than preserve the economic terms of a debt instrument) seems minimal.”