Guidance

Draft guidance on the taxation implications for individuals from the withdrawal of LIBOR and other benchmark rate reform

Updated 12 January 2021

This draft guidance paper explains HMRC’s view on the tax implications of changes to financial instruments held by individuals that is driven by benchmark reform.

It is of a general nature and is based on the law as at the date of publication.

London Inter-bank Offered Rate (LIBOR) is a set of interest rate benchmarks based on the rates at which banks are willing to borrow wholesale unsecured funds.

It is used in a large number of loans, derivatives and other financial instruments.

In line with a report by the Financial Stability Board in July 2014, attempts have been made to try to limit LIBOR submissions and rates to actual transactions to ensure the sustainability of the rate.

While significant improvements have been made to the benchmark since then, the market that LIBOR seeks to measure for unsecured wholesale term lending to banks, is no longer sufficiently active.

In a speech in 2017 the Financial Conduct Authority (FCA) indicated publicly that they do not intend to use their powers to compel panel banks to contribute to LIBOR after the end of 2021.

Panel banks have voluntarily agreed to continue providing submissions to LIBOR until then, but its publication cannot be guaranteed beyond this date.

On 23 June 2020, the Chancellor made a written ministerial statement indicating that the government will ensure the FCA’s powers are sufficient to manage an orderly transition from LIBOR. This will include extending the circumstances in which the FCA may require an administrator to change the methods of a critical benchmark and providing them the ability to specify limited continued use of LIBOR in legacy contracts.

Individuals cannot rely on the benchmark’s continued publication and will therefore need to continue to migrate away from LIBOR as a reference in their financial contracts.

It is likely that banks will contact affected parties to discuss their plans to either:

• change the terms of any existing financial instruments that use LIBOR
• replace their existing financial instruments with new instruments that do not use LIBOR

This paper explains HMRC’s view on the tax implications for individuals of changes to financial instruments driven by benchmark reform. It is of a general nature and is based on the law as at the date of publication.

Although this guidance refers specifically to LIBOR, other benchmark rates are also being withdrawn or otherwise reformed. For example:

• Euro Overnight Index Average (EONIA)
• US Effective Federal Funds Rate
• Euro Interbank Offered Rate (EURIBOR)

Individuals may therefore also be looking to restructure financial instruments which contain references to these other reference rates. The guidance below applies equally in those situations.

This guidance applies to changes to financial instruments where they make amendments to:

• replace the benchmark rate they refer to
• introduce or amend fallback provisions
• make incidental amendments that are consequential to replacing the benchmark rate

The fallback provisions this applies to determine how the contract should operate if the designated benchmark rate is permanently discontinued, is considered unrepresentative or otherwise cannot be used.

An example of incidental amendments that are consequential to replacing the benchmark rate is making amendments to the applicable interest margin to better equate the replacement rate with LIBOR or making additional payments to broadly preserve the parties’ economic position.

Contracts may be amended due to:

• direct negotiation
• changes in a bank’s standard terms and conditions
• a clearing house’s rulebook
• through the parties adopting industry standard language

Examples of industry standard language are:

• the International Swaps and Derivatives Association’s Benchmark Supplement, and IBOR Fallbacks Supplement, to the 2006 International Swaps and Derivatives Association Definitions and the 2020 IBOR Fallbacks Protocol (published on the 23 October 2020 to facilitate amendments to legacy contracts)
• for loans, the Loan Market Association template terms

International Swaps and Derivatives Association has also published a specific interbank offered rate fallbacks protocol on 23 October 2020 to facilitate amendments to legacy contracts..

It is thought that in the majority of cases the changes to the instrument made for the purpose of responding to benchmark reform will be relatively minor and that the economics of the transaction between the parties will be broadly maintained.

This is expected to be the case where an individual does no more than change their contracts in a demonstrably market standard way, for example by doing any of the following:

• adopting the language in the International Swaps and Derivatives Association or Loan Market Association documents above (or equivalent documents of other similar organisations)
• replacing the existing reference rate and associated conventions with the corresponding alternative reference rate and conventions used in the International Swaps and Derivatives Association or Loan Market Association documents (or equivalent documents of other similar organisations)
• incorporating any changes recommended by the Sterling Risk-Free Reference Rates Working Group or equivalent body outside the UK

We would expect the guidance to apply to such transactions.

References in this guidance to ‘financial instruments’ should include leasing and other contracts, as well as loans and derivatives, unless the context implies otherwise.

Individuals will need to consider their own circumstances carefully and make sure that any specific statutory provisions that are relevant are applied as appropriate. In cases where there is, or may have been, avoidance of tax, the application of the law (including anti-avoidance provisions) may result in a different tax treatment.

HMRC has also released similar guidance for businesses to refer to.

Most of the business guidance will not apply specifically to individuals. For example, there is no equivalent to the loan relationships and derivative contracts regimes.

However, there may be parts of that guidance that would be useful for individuals with more complex situations to refer to. For example, an individual that was subject to double tax treatment or who had previously sought clearance on a transaction may find the alternate guidance useful.

If you are not sure of the steps you need to take in relation to tax, then you should contact HMRC.

It is the responsibility of an individual to submit a Self Assessment tax return as appropriate.

What might replace LIBOR

There are a number of existing interest rate benchmarks which could replace LIBOR in a financial instrument.

The Sterling Risk Free Rate Working Group has recommended the Sterling Overnight Index Average as its preferred risk free rate to replace sterling LIBOR.

It is calculated by looking at the rate paid by banks on overnight funds and therefore needs to be aggregated in some way to be used over a term interest period.

Similar benchmarks have been recommended for different LIBOR currencies. For example Secured Overnight Financing Rate for the US dollar and Swiss Average Rate Overnight for the Swiss franc.

Introduction to the tax treatment

To correctly identify the tax implications of changing a financial instrument, it is important to identify both the nature of the debt and the impact any changes will have on the nature of the agreement between the parties.

A debt exists whenever money is owed to someone else. A debt is an asset in the hands of the creditor or lender and a liability in the hands of the debtor or borrower.

A debt asset will be disposed of when the debt is repaid or if the lender sells or transfers the debt.

There are only a limited number of circumstances in which a disposal gives rise to a chargeable gain or allowable loss.

Normally this is where the debt is of the type that the lender could sell it to someone, this means the terms of the debt make it marketable.

Financial instruments held by individuals as investments are generally within the scope of Capital Gains Tax. The exception is qualifying capital bonds which are exempt from Capital Gains Tax.

Qualifying capital bonds are explained further below.

Once the nature of the financial instrument has been identified it will be important to identify if the amendment to the agreement results in a disposal for Capital Gains Tax purposes.

This is considered below along with the treatment of additional payments made as a result of, or to facilitate, the amendment.

Amending a financial instrument

Depending on the circumstances and terms of the legal documents involved, the amendment of a financial instrument will be either:

• the continuation and variation of an existing financial instrument
• the creation of a new financial instrument and cancellation of the original

The intention of the parties, and how this is reflected in the legal documents, will be significant factors in determining whether the changes legally constitute an amendment to an existing financial instrument, or the redemption and replacement of an existing financial instrument with a new financial instrument.

Where the parties agree to change the terms of the instrument for the purposes of responding to the withdrawal of LIBOR, HMRC would normally view this as a variation of the existing instrument.

The amended contract should be regarded as the same contract and entered into at the same time as the original one.

A key question for Capital Gains Tax will be whether a disposal has taken place in relation to the amended financial instrument.

This is considered below along with the treatment of additional payments made as a result of or to facilitate the amendment.

Continuation of an existing Financial Instrument

Where the parties agree to change the terms of the instrument for the purposes of responding to the withdrawal of LIBOR, HMRC would normally view this as a variation of the existing instrument.

The amended contract should be treated as the same contract and entered into at the same time as the original one.

For example, this would apply, where the parties agree to replace LIBOR for one of the new reference rates or with a fixed interest rate.

It does not matter if the spread on the instrument needs to be amended slightly, to better equate the replacement rate with LIBOR or if additional payments are made between the parties. Provided the economics of the transaction remain broadly the same.

In this case no disposal will have taken place in relation to the original contract and hence there will be no Capital Gains Tax to pay at this time as a direct result of the amendment.

Creation of a new financial instrument

The changes might result in the termination of the existing contract and the creation of a new one. Normally this would occur where the parties to the contract both agree to end the original contract and replace it with a new one.

A contract would also be considered as terminated, and a new contract created for tax purposes, where the changes made to the original contract are so extensive that the financial instrument cannot be seen as continuing.

In these cases, a disposal will have taken place at the time that the old instrument has been terminated unless certain reorganisation rules apply.

Guidance on these rules can be found in HMRC’s Capital Gains manual CG55000.

At the point the disposal occurs in relation to the old instrument Capital Gains Tax will be chargeable on the gain or loss arising from that end of the arrangement.

The gain or loss for Capital Gains Tax purposes from this disposal will usually be calculated by subtracting the acquisition cost of the instrument from the disposal proceeds at the point of disposal.

The disposal proceeds will normally be taken to be the market value of the new financial instrument, although an adjustment would be needed if the transaction was not at arm’s length.

Further guidance on valuing the disposal proceeds can be found at CG13090. Other costs may also be allowable depending on the circumstances. Further guidance can be found at CG15150.

Making an additional payment

Where there is an amendment to a financial instrument, or a financial instrument is removed and replaced with a new instrument. There may be circumstances where one party to the instrument might need to make a one-off payment, or series of payments, to the other party to compensate for the changes in terms when the financial instrument is amended to respond to benchmark form.

Who receives this payment depends on how the expected cash flows under LIBOR compare with the expected cash flows under the new reference rate.

For example, if the financial instrument was a floating rate bond and the expected cash flows representing payments of interest are lower under the new reference rate, the borrower might make a payment to the lender to make up for the shortfall.

Where there is a loan between an individual, who is the lender and a borrower, and the borrower is required to make an additional payment to the individual as a direct result of LIBOR reform.

This payment would be interest in nature as it shares all the same hallmarks of interest. In particular, the amount represents compensation for the use of the money advanced by the individual.

The borrower may have to deduct Income Tax on the payments in a similar way to the ordinary payments of interest on the instrument. The individual receiving the payment would include this as an interest receipt subject to Income Tax.

Where the payment goes in the opposite direction, and an individual as the lender has to make a payment to the borrower. This cannot be interest because the individual does not have the use of any money and so the payment cannot be said to be compensation for the use of money.

Instead, this payment is likely to be an expense incurred by the individual to make sure the borrower continues to make interest payments considering that these will now have increased.

It is unlikely the individual when making the payment will need to deduct Income Tax on any such payment because such an expense should not fall within Part 15 of the Income Tax Act 2007.

The individual will not be able to claim tax relief for this expense.

Qualifying Corporate Bonds

The expression ‘corporate bond’ is a general commercial term for securities issued by companies to raise debt finance and represents a loan relationship. This means a debt arising from the loan of money.

Find out more information by reading CFM30140

Qualifying corporate bonds have special features that mean that when they are sold or otherwise disposed of, there are no chargeable gains or allowable losses arising.

HMRC’s manual at CG53700C provides further detail of which corporate bonds meet the qualifying corporate bond definition.

Generally if the security is a normal commercial loan and expressed in sterling then it may be a qualifying corporate bond.

Get more information

If you have any comments on the draft guidance, for example additional issues that should be included or points that could be expressed more clearly, these should be sent to Liang Tang at [email protected] by 10 December 2020.