Clearing Up the Tax Considerations of the Cleared Swap Discounting Transitions

• Published in: Journal of Taxation of Financial Products 2020-01, Vol.17 (3), p.29-38
• Main Authors: Mosby, Matthew, Raglan, Hubert, Tompkins, Joshua S
• Format: Article
• Language: English
• Subjects: Borrowing; Central banks; Collateral; Eurozone; Financial instruments; LIBOR; Net present value; Secured overnight financing rate; SOFR
• ISSN: 1529-9287

Cases of attempted market manipulation and false reporting of global reference rates, together with the post-financial crisis decline in liquidity in interbank unsecured funding markets, have undermined confidence in the reliability and robustness of LIBOR.2 In response to these issues, the U.K. Financial Conduct Authority announced in July 2017 that all currency and term variants of LIBOR will be phased out after 2021.3 Since then, the U.K. Financial Conduct Authority and other official sector bodies have made several announcements regarding the need to transition from LIBOR to alternative rates, and market participants have been strongly advised of the need to ensure they are prepared for this transition by the end of 2021. The Secured Overnight Financing Rate ("SOFR"), which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities, was selected to replace USD LIBOR.4 In the European Union, the selection of an alternative reference rate to replace EUR LIBOR was led by the Working Group on Risk-Free Reference Rates for the Euro Area.5 The Euro Short-Term Rate ("€STR"), which is calculated on the wholesale Euro unsecured overnight borrowing costs of Euro area banks, was selected to replace EUR LIBOR.6 Much ink has been spilled about the forthcoming LIBOR transition and Proposed Reg. 1.1001-6 (the "Proposed IBOR Regulation"), which is intended to reduce the potential for tax disruption associated with the transition to the new reference rates.7 One aspect of LIBOR phaseout that has received less scrutiny is the interim transition of cleared swap discounting methodologies to SOFR (for USD denominated swaps) and €STR (for EUR denominated swaps). To neutralize the value transfer from the EONIA€STR Discounting Rate change, the CCPs processed a one-time "Adjustment Payment" equal to the difference between the net present value of all future cash flows calculated using €STR discounting and the net present value calculated using EONIA discounting.13 Economics of the EFFR-SOFR Transition The Discounting Rate used for USD denominated cleared swaps is scheduled to be transitioned from the daily Effective Federal Funds Rate ("EFFR") to SOFR in October 2020.14 Similar to the EONIA-€STR transition, the EFFR-SOFR Discounting Rate transition will affect the Variation Margin required to be posted, and this value change will be offset by an Adjustment Payment. For debt instruments, the Proposed IBOR Regulation provides that an alterat