A crucial shift from the use of the London Interbank Offered Rate (LIBOR) is gaining momentum, with news looking at the end of LIBOR by December 2021. This raises an alarm for a closer relook and maybe a tweak, on all transactions involving the use of this historically dependent base rate. Key tax/transfer pricing implications of the move that will impact us here in India (as also elsewhere) are discussed below.
What is LIBOR?
The LIBOR is an unsecured benchmark interest rate at which major global banks lend to one another. This rate is used as a reference rate across the world, for various transactions worth a trillion dollars, such as, loans, derivatives, mortgages etc., which is calculated based on submissions from select banks. Over a period of time, LIBOR was based on judgements rather than actual transactions, questioning the reliability of market refection. Further, in recent years, the governance process underlying LIBOR has been brought under the scanner, raising grave concerns on the authenticity of the LIBOR. As an outcome, the UK’s Financial Conduct Authority announced that after 2021, it will no longer compel or persuade banks to submit LIBOR.
Alternative Reference Rates
In light of the background above, various countries have started to select alternative reference rates (ARR) to replace LIBOR:
- The United States has selected the Secured Overnight Financing Rate (SOFR);
- The British pound sterling LIBOR to be replaced by the Sterling Overnight Index Average (SONIA);
- The Tokyo Overnight Average Rate (TONAR) will replace yen LIBOR;
- The Swiss Franc LIBOR to be replaced by the Swiss Average Rate Overnight (SARON).
Challenges in replacing LIBOR
While such ARRs can be used as replacements, simply substituting the ARR would not be possible considering the elements of differentiation as below:
- The ARRs are all overnight rates, in contrast to the LIBOR which specifies the term of the rates such as 3 month LIBOR, 6 months LIBOR etc.;
- The ARR rates differ from each other in terms of security i.e. SONIA and TONAR are unsecured rates, whereas SOFR and SARON are secured rates;
- The LIBOR has an element of credit risk embedded, while the ARRs are nearly risk-free rates
Vital impact areas – Intercompany financial instruments
While waning away from LIBOR would lead to fundamental issues for financial institutions in their day to day dealing, among others issues, several corporates would have to deal with the impact on their intercompany financial transactions, emanating from a transfer pricing perspective, such as loans, cash pooling structures etc. Groups will need to deep dive into their existing arrangements referenced to LIBOR and look at alternatives, and sync group policies wherever required.
Company to Company Loans
If the current rate of interest is LIBOR + 100 bps, the Company would now have to look at replacing the LIBOR with an ARR. For example, SOFR + a spread adjusted to factor in the credit risk, term and unsecured nature of LIBOR.
Loans from the Parent company to subsidiaries
In the existing state, the group would have considered LIBOR as the base rate (which is unsecured and factors credit risk) and would have adjusted the spread for currency risk factors. In a post-LIBOR scenario, considering that the base rate itself is not constant in terms of the embedded elements of security and credit risk, i.e. in one country a SONAR (unsecured rate), and in another country, a SOFR (secured rate) would be considered, the spread would need to be adjusted considering the difference in features.
A parent provides loans to multiple group entities denominated in various currencies across the globe. Impact on interest rate swaps would need to be evaluated, for exchange of fixed rates for floating rates and vice versa between third parties and interbank swaps.
Impact on financial contracts
Corporates would have to consider the impact on financial contracts entered into between group entities. Check the following scenarios:
- For existing agreements expiring before 2021, one could consider continuing with LIBOR as the base rate, however, as we move towards 2021 there is a possibility of a further sink away from market refection.
- In case of agreements that are continuing beyond 2021, one would probably consider the need to amend the agreement to insert fallback language, to avoid complexities at a future date on the demise of the LIBOR.
- For agreements in the stage of execution, one could consider the use of ARR, or insert appropriate fallback language in case of the use of LIBOR.
Impact on accounting and reporting
Accounting and reporting impact to be evaluated based on accounting standards followed. Tax treatment of this transition will require clarity from regulatory authorities, i.e. what would be the nature and treatment of a one-time payment (if any) on shift to an ARR. Updating of financial disclosures wherever appropriate.
Impact on limitations on interest deductions
Implications of change in LIBOR would require close monitoring, of the direct impact on limitations on interest deductions under section 94B of the Income Tax Act, 1961 (the ‘Act’).
Impact on the computation of interest
Computation of interest income as prescribed in Rule 94B of the Income Tax Rules, 1962 in relation to secondary adjustment, for repatriation of excess money pursuant to Section 92CE of the Act, would require a replacement of LIBOR.
APAs & Safe Harbours
APA’s and Safe Harbours would require renegotiation to account for the shift. Non-financial transaction-related APAs would also need to redefine the overdue receivables rate, which is currently pegged to LIBOR.
It would be sagacious of corporates to plunge into their financial dealings and assess all impact areas, such as the ARR and the adjusted spread, tax implications, contractual implications, and operational & technology readiness. Corporates would need to assess the change in the spread over the ARR and its impact on the group. There are certain push backs that companies may face in terms of non-availability of publicly available data, to determine arm’s length rates from companies that may have transitioned to ARRs. For large conglomerates which have complex funding structures worldwide, it would be imperative to assess the risk impact of such a transition, and approach this shift meticulously.
Countries across the globe have set up committees/working groups to deal with this transition, such as the ARR committee in the US, the Work Group on Sterling Risk-Free Reference Rates in the UK, the National Working Group on Swiss Franc Reference Rate etc. In India, the regulators are yet to take steps toward this changeover. This could be a wait and watch on the ARRs adopted by countries based on their respective currency which will in India impact intercompany dealings, APAs, Safe Harbour and other regulatory implications which are pegged to LIBOR. As the chronometer ticks, the end of LIBOR is not too far off.
Courtesy, The Chamber of Tax Consultants (CTC). Written by a young member Cheryl Jagtap and vetted by CA Anish M Thacker, Vice President, CTC (2019-20)