The London inter-bank offered rate (LIBOR) is due to disappear at the end of 2021. This might not matter if these rates were not the key reference rate in capital markets, underpinning approximately $300 trillion of financial contracts.
The end of LIBOR will have far-reaching implications for transfer pricing (TP) arrangements around the world. All future inter-company loans will need to be pegged to a new rate, which has yet to be decided. There are still many agreements that will outlive LIBOR where fall-back options will come into play. But there is a problem with the fall-back clauses.
“Most fall-back and market disruption clauses only anticipated a temporary disruption more than a total disappearance,” said Edouard Nguyen, treasury director at Axis Alternatives in Paris. “Some changes have been requested to make the new rates as precise as possible and to make sure the benchmark could be disputed or at least challenged.”
“Obviously, this is difficult and banks are quite reluctant to go down this road, considering that there is a great deal of uncertainty on the transition to new euro benchmark rates,” he added.
The Loan Market Association (LMA) has released "boilerplate" language for contracts to address the end of LIBOR, but it is unclear how this would work with legacy contracts with no reference to alternative rates. However, it is a useful way of preparing in the here and now.
"It's holding language and not intended to be a long term solution," said Joel Cooper, partner
The two immediate alternatives to LIBOR are the sterling overnight index average (SONIA) and secured overnight financing rate (SOFR). These two rates are being used, alongside LIBOR, by central banks until the London inter-bank rate is phased out.
"To the extent that alternative benchmarks, when adjusted for tenor if necessary, give rise to a different result, one party is likely to be in a different position to now," said Rachit Agarwal, transfer pricing director at DLA Piper. "Over time the markets may adjust and margins will change accordingly."
"There will be some challenges to overcome," Agarwal told TP Week. "We will be monitoring what the commercial lending markets and use that to inform how we advise our clients."
SONIA and SOFR were singled out by regulators as ‘nearly risk-free rates’ (RFRs). However, there are concerns that the switchover will result in a value transfer and any adjustment to a new rate would have to include a new spread to make up for this transfer.
“LIBOR takes into account credit-risk, whereas RFRs such as SONIA do not,” said Suze McDonald, international tax partner at RSM in London. “The rates quoted are likely to differ. Therefore there will likely be a tax impact that needs to be quantified.”
“HMRC may argue that third parties would not agree to a revision of such a key term as the interest rate without a wider review and potential update of the terms and conditions of the loan,” she told TP Week.
Industry bodies are searching for a uniform adjustment approach, but it’s likely there will be different approaches for different kinds of
The fear is that the shift to alternative rates will see a fall in basis points, if not more volatile fluctuations in the future. LIBOR has been kept at a low but stable level ever since the 2008 financial crisis. But everything comes to an end eventually and markets are all about change.
The ripple effect
All around the world taxpayers will need to consider whether replacement interest rates for such contracts meet long-held standards. Many companies will have to change their documentation because of the rate change and sometimes with just one or two months’ notice.
One TP director at a US financial group said the conversion process would inform transfer pricing strategy “with the preference being to allow existing LIBOR pegged transactions to run off against the quoted LIBOR index”.
There is a real concern that some cross-border loan agreements could lose their tax-free status in the US because of a shift in the rates.
The interest payments would have to be reassessed and possibly reclassified as dividends. This could be costly to any multinational operating in the US.
“You have to be sure that your loan is a real loan under US law, meaning it has to have an interest rate, it should not depend on the result of the US company,” said Noah Gaoua, head of tax at Novares in Paris.
“Any loan that I have with my US subsidiary, I review carefully, even with help from my US tax advisor,” he stressed. “It has to be a real loan avoiding any doubt because the tax consequences can be huge.”
Keeping close track of the market is one way to avoid the potentially damaging fallout. Some corporates are trying to mitigate the transfer pricing risk by including new wording in agreements to stress that the new rate should be at arm’s length conditions.
“Groups should carry out a benchmarking exercise to determine whether SONIA or other adopted measure is likely to be a suitable basis for determining the arm’s length range for TP purposes based on current facts and circumstances,” Suze McDonald said.
“Any increases to the interest expense of the borrower will need to be assessed also from thin
The end of LIBOR throws vast amounts of financial transactions into doubt and inter-company lending is just one site of uncertainty. But the markets and the regulators will find ways to manage this change just as they have in the past.
This article was produced in collaboration with ITR reporter Danish Mehboob and Practice Insight reporter Thomas Helm.