In July 2017, the Chief Executive of the UK Financial Conduct Authority (FCA) announced that firms should discontinue the use of the London Interbank Offered Rate (LIBOR) in favour of overnight risk-free rates (RFRs). Although registered and administered in the UK, LIBOR is a benchmark that underpins contracts affecting banks, asset managers, insurers and corporates globally. The transition must be completed by the end of 2021, as the continuation of LIBOR will not be guaranteed to market participants after that date.
In addition, the Euro Overnight Index Average (EONIA) and the Euro Interbank Offered Rate (EURIBOR) will not, in their current form, be compliant with the EU Benchmarks Regulation (BMR) after 1 January 2020. The practical impact is that companies with financial arrangements tied to Interbank Offered Rates (IBORs) need to implement timely transition plans, which will include assessing the impact of these changes on transfer pricing arrangements. As RFRs are not a direct replacement for IBORs, multinational enterprises (MNEs) need to understand the potential transfer pricing impact of the IBOR transition and mitigate any potential risk.
IBORs such as the LIBOR, EONIA and EURIBOR are floating rates that are calculated and published by the administrator of each rate on a daily basis. They are based on the IBOR rates at which a group of leading global banks can borrow unsecured short-term wholesale funds in the interbank market. However, IBOR submissions are not necessarily anchored to actual transactions. The absence of active underlying markets raised questions about the sustainability of the IBOR benchmarks as they underpin approximately USD 300 trillion in financial products. Consequently, working groups were established in different markets to reform major interest rate benchmarks and identify alternative nearly risk-free rates. For further information and an overview of the proposed RFRs see “Interbank offered rate (IBOR), the journey ahead” and “LIBOR transition - Setting your firm up for success.”
What are the key transfer pricing implications and how can they be addressed?
One of the main transfer pricing implications resulting from the IBOR transition is that appropriate spreads to be applied to RFRs would need to be redetermined. In light of the structural differences between IBORs and RFRs, the mechanics of determining appropriate spreads on RFRs may not be straightforward. For instance, RFRs generally are currency-specific, overnight rates and they are virtually risk-free. IBORs were available in various currencies and maturities and embedded a credit risk associated with bank borrowing. A financial product transferred from IBOR to a new RFR could have an undeniable diverse market value resulting in potential losses or gains depending on the role of the party involved in the same financial transaction, e.g. lender and borrower.
Firms, therefore, will need to carefully review their valuation methodologies and pricing of intercompany financial arrangements to prevent shifts of value from one jurisdiction to another, which may trigger potential transfer pricing exposures.
Changes in the fair value of contracts may have tax repercussions on the amount of direct and indirect taxes payable, including deferred taxes. Indeed, where tax law follows the accounting treatment, a profit and loss impact may give rise to a taxable credit or deductible debit. The renegotiation or termination of a contract also may require immediate tax recognition in accordance with local tax rules. These tax risks can be mitigated by reviewing existing cross-border tax structures and redesigning them to be more efficient ahead of the expected transition deadlines.
Alternative rates for a specific currency may not be available in the early stages, until a complete transition has taken place. In such cases, it may be prudent to include fallback provisions in intercompany contracts, e.g. lenders may be willing to include language that states the parties will agree a new replacement index when new RFRs become available. These differences may create difficulties in relation to typical multicurrency arrangements and other complex intercompany structures such as cash pooling, factoring, currency swaps, hedging, etc.
During the transition period, differences in market liquidity also may give rise to challenges in accessing comparable data, which may adversely affect the robustness of the transfer pricing analyses.
Finally, the required changes and transitions may trigger refinancing, or step-ups/step-downs in rates during the life of existing contracts, which may affect the yields of existing instruments and/or the arm’s length market value of such arrangements. Having regard to the latest draft guidance provided by the OECD in relation to financial transactions, the accurate delineation of a financial transaction will be key in determining the most appropriate treatment of such transition issues.
Intercompany financing transactions increasingly have been the focus of attention from the tax authorities in recent years, particularly within non-financial services firms. The IBOR transition may be one of the more prominent current changes in financial markets and MNEs, therefore, should be committed to assessing their financial arrangements and implementing appropriate transition and mitigation plans.
If you would like to discuss more on this topic, please do reach out to one of the key contacts below: