Signs of the demise of the London Interbank Offered Rate (Libor) were already apparent in 2017 when there was a global issue that it would be terminated as the global benchmark interest rate after the end of 2021.
Libor is the reference of the average interest rate for financial instruments that represents an indication of unsecured interbank lending rates, particularly in London. Libor is an old creature and has been used as the global benchmark interest rate for decades. It is based on different currencies (i.e., USD, EUR, GBP, JPY and CHF) and loan terms (overnight, one week, one month, two months, three months, six months, and 12 months). Hence, it has been widely used in determining the rate for several types of financial instruments. Libor is also used as both a performance and risk benchmark.
However, rather than using the actual interest rate, Libor is calculated by estimating the daily interest rate. It is managed by the British Bankers’ Association (BBA), based on the reliability of rates reported by several of the world’s major banks. For the calculation, Libor compiles a panel of banks that submits daily estimates for interbank borrowing costs.
The turning point for use of the rate happened in 2012 when the Libor scandal was revealed. Several major banks, including Deutsche Bank, Barclays, Citigroup, JP Morgan Chase and the Royal Bank of Scotland were caught colluding and manipulating interest rates to benefit their derivatives traders. As a result, this raised concerns about the validity and reliability of using Libor as a global benchmark for financial transactions.
In response, to improve the integrity of Libor, the UK Financial Conduct Authority (FCA) transferred its administration from the BBA to the Intercontinental Exchange Benchmark Administration (IBA). These efforts, however, were deemed insufficient to regain market confidence in Libor. Therefore, the FCA announced in 2017 that the bank panel would no longer use Libor, and the official termination date – set for the end of 2021 – was announced in early 2021 by the FCA and IBA.
To ensure a smooth transition, the Libor termination has been introduced gradually – after the end of 2021, EUR Libor, GBP Libor, JPY Libor and CHF Libor had been terminated for all loan terms, while the USD Libor had been terminated only for one-week and two--month terms.
Further, the remaining loan terms for USD Libor, such as overnight, one month, three months, six months and 12 months, will be terminated by the end of June 2023. The gradual termination of USD Libor is intended to give additional time for the market to renegotiate their financial agreements. However, considering the USD Libor for the remaining loan terms that are still available, the financial agreement is no longer allowed to use Libor as the reference rate after the end of 2021.
Alternative risk-free rate
Following the announcement of Libor termination, authorities from each country’s Libor currency – namely the Federal Reserve Bank of New York (The Fed), European Central Bank (ECB), Bank of England (BoE), Bank of Japan (BoJ), Swiss National Bank (SNB), and another key financial market in the world including Singapore and Hong Kong –have been preparing to abandon Libor in current and future settings by finding and selecting an alternative risk-free rate (ARR).
To increase credibility, transparency and reduce the risk of manipulation, the authorities finally set the ARR that was formed based on actual lending transactions’ interest rate at the highest liquid tenor in the money market (fully transaction-based), as follows:
- US with US$ currencies as the Secured Overnight Financial Rate (SOFR);
- EU with EUR currencies as Euro Short-Term Rate (€STR);
- UK with GBP currencies as Sterling Overnight Index Average (SONIA);
- Japan with JPY currencies as the Tokyo Overnight Average Rate (TONA), Tokyo Interbank Offered Rate (TIBOR), and Tokyo Term Risk-Free Rate (TORF);
- Switzerland with CHF currencies as the Swiss Average Rate Overnight (SARON);
- Singapore with SGD currencies as the Singapore Overnight Rate Average (SORA); and
- Hong Kong with HKD currencies as the Hong Kong Dollar Overnight Index Average (HONIA).
The Fed identified the SOFR as the more resilient rate for use in certain new US dollar financial transactions, which reflects market interest more than Libor because it is a broad measure of the cost of borrowing cash overnight collateralised on transactions in the US Treasury securities.
The European Commission replaced the CHF Libor and Euro Overnight Index Average with SARON and €STR. SARON represents the overnight interest rate of the secured money market for Swiss francs, while €STR reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area. In both cases, an adjustment spread is applied so that undue value transfer is limited. BoE provides the new reference rate with SONIA, which is based on actual unsecured transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions and other institutional investors.
In Japan, BoJ has identified the TIBOR, TONA and TORF as the country’s Libor alternatives. TIBOR is calculated and published by the Japanese Bankers Association based on interbank rates submitted by 15 financial institutions in Japan, while TONA and TOFR serve as the reference rate for the JPY unsecured overnight index swap (OIS) market. TONA is the near-ARR for the Japanese yen market.
The SORA, published by the Monetary Authority of Singapore, is the volume-weighted average rate of borrowing transactions in the unsecured overnight interbank Singapore dollar cash market in Singapore. The Treasury Markets Association identified the HONIA as an alternative reference rate to the Hong Kong Interbank Offered Rate (HIBOR) in Hong Kong, which is also a risk-free overnight interbank funding rate based solely on transaction data. Hong Kong has no plans to discontinue HIBOR.
The transition from Libor to an ARR will cause significant disruption in the financial transactions including related party transactions, particularly financial agreements that use floating interest rates with Libor reference rates. Taxpayers must ensure that their intra-group financial agreements are in accordance with the arm’s-length principle requirements. There will be a strong possibility that taxpayers need to amend the ongoing intra-group financial agreement to adapt to the current situation.
Neither the OECD nor the UN has released the guidelines regarding the Libor transition. Based on these considerations, the financial agreement amendment done by the taxpayer to change Libor to ARRs should be at arm’s-length, since the amendment should reflect the conditions that could be found between independent parties. As is to be expected, independent parties will use in advance ARRs as a replacement for the Libor in most financial transactions.
“The challenges in facing the Libor transition for Indonesia will be similar to those in other parts of the world.”
The transition presents practical challenges in realigning intra-group financial agreements. This includes potential fallback provisions as well as the substitution of ARR for Libor. A fallback provision is a contract clause that specifies which rate should be used if the initially agreed upon benchmark rate (e.g., Libor) is no longer available. Without a fallback, a party tied to a contract could potentially result in a dispute due to the unavailability of the referenced benchmark rate.
The necessary amendments to the intra-group financial agreement include the establishment of a contractual term of interest rates, setting a spread adjustment, and adjusting the notice of payment. Considering the difference in loan terms in ARR, which only has overnight terms and does not have credit risk, to determine the interest rate need to calculate the compounding interest rate from the ARR over a certain period. In addition to determining the ARR with different maturities, economic differences between Libor and the ARR must be considered. For example, related to credit risk spread, market participants are not expected to give up on the spread between Libor and an ARR. Therefore, an additional credit adjustment spread should be added to the term ARR.
It should be noted that the application of the arm’s-length principle depends on determining the conditions that an independent enterprise would have agreed to in comparable transactions under comparable conditions. Correspondingly, it is critical to identify the comparability analysis, which includes contractual terms, functional analysis, characteristics, economic conditions and business strategies. In particular, functional analysis to determine the contractual risk assumptions, the lender’s and borrower’s perspectives would typically be considered. The assumed risk simultaneously will have an impact on the determination of the interest rate.
To mitigate transfer pricing (TP) issues and ensure the rate is at arm’s-length, taxpayers are advised to perform a TP analysis by performing the price or benchmark-setting in accordance with the ex-ante approach. Consequently, amending the intra-group financial agreement regularly would necessitate benchmark setting. However, to find comparable transactions that use an ARR interest rate may be quite a challenge since currently most comparable data in public databases is provided on a historical basis, which means the majority of data available are still in Libor version. This can force taxpayers to conduct more in-depth analysis, for example by using credit default swaps or economic modelling to obtain more relevant results than analysis with benchmarks from public data.
The Indonesian perspective
The TP methods for intra-group financial transactions in Indonesia does not differ from the OECD Transfer Pricing Guidelines. Indonesia’s domestic regulation has stated that the comparable uncontrolled price (CUP) method is the primary approach for intra-group financial transactions analysis. In the CUP method, comparable data can be collected from two sources, which are from internal taxpayer data or by using public database. In practice, there are several difficulties in applying the CUP method. Public database appears to have limited financial transaction agreements sourced from Indonesia. As a result, a lot of comparable adjustments may be required to achieve a higher degree of comparability.
If the CUP method is not possible to apply, it is common to use alternative methods to understand the business purpose of intra-group financial transactions. Commonly used alternative methods include analysis on cost of funds and the return of realistic alternative transactions, which are also mentioned in the OECD Transfer Pricing Guidelines. In using the cost of funds approach, the loan would be priced based on the lender’s cost in raising the funds to lend plus margin, while the analysis for return of realistic alternative transactions analyses the possible margins that lenders will get from other financial instruments.
With all the limitations that exist in the use of the CUP method, the arm’s-length principle testing can be focused also on the substance of the transactions. Indonesia’s domestic regulations explain the preliminary steps that must be conducted in testing intra-group financial transactions, such as ascertaining the substance of the actual situation, economic benefits to lender and borrower, and complying with the minimum standards of loan agreement legal documentation.
If the preliminary test is not met, then the financial transaction can be recharacterised from loan transaction to an equity investment transaction, which is not allowed to charge interest. From the borrower’s perspective, it is also necessary that they have complied with the thin cap requirement with the current ratio between debt and equity balance set at maximum ratio of 4:1. This term may be changed due to recent developments where there is a possibility that there will be a new regulation that amends thin cap regulation by using certain percentage of interest expense to EBITDA instead of ratio on debt to equity.
Related to Libor transition, it is known that in Indonesia Libor is also commonly used as a reference rate especially for transactions with US dollars. Consequently, the transition of Libor will significantly impact Indonesia’s financial market and intra-group financial transactions. In response to the Libor transition, Indonesia established the National Working Group on Benchmark Reform (NWGBR) to address the discontinuation of the use of Libor and work to improve the credibility of the benchmark rate in the domestic financial market.
The NWGBR provides a Libor transitional guide to the market, particularly for those with Libor exposure, by recommending the use of ARR on the new financial arrangement in accordance with the recommendations of the authorities of each Libor currency country, negotiating an outstanding agreement with counter parties to agree on a fallback clause, and stay up to date on Libor transition process developments.
For local currency, the ARR provided by Bank of Indonesia is IndONIA (Indonesia Overnight Index Average), which replaces JIBOR (Jakarta Interbank Offered Rate). IndONIA is designed as a money market benchmark rate and reference for setting loan interest rates, pricing financial instruments and measuring the performance of financial instruments.
IndONIA is determined based on the average overnight interest rate for rupiah lending and lending transactions by calculating a weighted average based on the nominal transaction value (volume-weighted average) of all transaction data made on the day of the transaction. IndONIA is reported to Bank of Indonesia daily by all banks in Indonesia.
The challenges in facing the Libor transition for Indonesia will be similar to those in other parts of the world. The challenges will be in reviewing the contractual terms of interest rates and setting a spread adjustment, especially in relation to the limited data for benchmarking. Furthermore, the taxpayer will need to properly amend their financial agreement and plan to document such analysis in their TP documentation to support and document their transition-related TP policies.
Romi Irawan is a partner of TP services at DDTC. He is an experienced practitioner in disputes and has vast experience in handling TP issues for clients involved in various industries.
Romi is a regular speaker at various seminars and training programmes on TP-related topics organised by DDTC, and he frequently participates as a trainer and speaker in forums and group discussions held by private institutions and government agencies. In 2020, he was named as a TP leader in World Tax’s dedicated leaders guide.
Romi received his bachelor’s degree in financial management from the University of Indonesia, his master’s degree in corporate financial management from Gadjah Mada University and his subsequent master’s degree in international taxation law from the Vienna University of Economics and Business in Austria, under a full scholarship from DDTC.
|Muhammad Putrawal Utama|
Muhammad Putrawal Utama is manager of TP services at DDTC. He has been involved in TP documentation, advisory, litigation services, mutual agreement procedure and advanced pricing agreement for clients in various industries, such as automotive, oil and gas, electronic, pulp and paper, finance, palm oil and coal mining.
Muhammad has been certified for his advanced diploma in international taxation from the UK Chartered Institute of Taxation, on the principles of international taxation and of corporate international taxation.
Muhammad also leads a specialist team that handles TP issues related to intangibles and financial transactions.
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