Regulators globally are spearheading one of the most complex transformation programs in recent times, affecting both financial firms and corporations, under which existing interbank rates (IBR) gradually will transition to alternative risk-free rates (RFRs). The decision to transition from IBRs to RFRs stems from various factors, including declining activity in underlying markets, the subjective nature of rates in the absence of sufficient transaction data and the need to take steps to ensure the integrity of financial markets.
Europe is one of the first movers in this area, where the Euro Interbank Offered Rate (EURIBOR) and the Euro Overnight Index Average (EONIA) are transitioning to the new Euro Short-Term Rate (€STER) as from 2020. Given that interbank rates are closely embedded in the day-to-day activities of both providers and users of financial services, even identifying a firm’s exposures can be a highly complicated task.
The transition will be complex due to significant differences between RFRs and IBRs by region, tenor currency and their basis. RFRs are overnight indices with no term structure, nearly risk-free and based on actual transactions while IBRs are term rates, reflect perceived credit risk and are survey-based.
One of the key challenges relates to the potential tax impact of the transition. In essence, differences in the construction of RFRs and their term structure/tenor could result in tax risks where a cross-border transfer of part of the value of financial assets/liabilities occurs.
Tax departments will need to focus on at least five areas to manage the transition to RFRs:
1. RFRs are constructed differently
RFRs are almost risk-free, whereas IBRs reflect perceived credit risk. This implies that RFRs are lower than IBRs. The transition could affect directly expected cash flows from the contracts/products on which they are based, i.e. a trade transitioning to RFRs may have a different market value over time than it otherwise would have had. This will require changes to valuation tools, product design, hedging strategies and funding.
2. Differences in term structure/tenors
There are differences in the term structure and availability of tenors for the new RFRs. As an example, the London Interbank Offered Rate (LIBOR) exists in seven tenors (from overnight/spot to 12 months) across five currencies. In contrast, the new RFRs are overnight indices and currently have no term structure.
3. Availability of historic data
For taxpayers that use IBRs for price-testing purposes, the transition will give rise to practical challenges since historical data is not yet available for the new RFRs, while data for traditional IBRs soon will no longer be available.
4. Recalibrating contracts/agreements
The transition also will give rise to practical challenges regarding how to (re-)calibrate legacy contracts and intercompany agreements. This includes potential fallback provisions and the replacement of existing IBRs with new RFRs or transitional rates. Relying on fallback provisions may change product economics and create financial and operational risk because such provisions typically are designed to deal with the temporary unavailability of reference rates rather than their permanent cessation. Relying on updated fallback clauses could create operational risks (ranging from new/different fallback formulae, calculation of new interest payments and valuations).
5. Dealing with transition costs
The transition likely will result in significant investments in information technology/enterprise resource planning (IT/ERP) infrastructure, external fees and internal project costs. Financial services firms and corporations alike will need to determine the tax treatment of the transition costs, where/how to capture and allocate relevant costs and what mark-ups to apply, and they will need to establish the legal basis for recharges and update relevant documentation.
European regulators indicated that a transitional use of EURIBOR might be possible under a hybrid method as long as the number of contributors remains relevant while EONIA has been transitionally “recalibrated” to €STR plus 8.5bps.
It should become clear that the transition from IBRs to RFRs is one of the most complex transformation programs in recent times. Considering that IBRs are embedded so closely in the day-to-day activities of both providers and users of financial services (regulated and unregulated), stakeholders should keep all aspects of the transition, including the potential tax impact, on their radar and proactively include tax departments in the transition program.
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