IBOR transition


IBOR transition

Transfer pricing implications of inter-bank rates transition

Authors: Cristina Blindu (LU) & Ismail Candan (LU)

One of the most important changes to affect the financial services sector is now closer than ever. Since its announcement in March 2021, the Financial Conduct Authority (FCA) and ICE Benchmark Administration (IBA), the authorized and regulated administrator of LIBOR, will no longer seek to persuade panel member banks to submit quotes for interbank offered rates (IBOR) after the end of 2021. This affects the publication of Euros, Swiss francs, Japanese yen, and Pound Sterling currencies for all tenors and US-dollars for one week and two months. The publication of US dollars for overnights, one, three, six, and 12 months will cease on 30 June 2023. It is important to mention that the EURIBOR was reformed in 2019 using a hybrid methodology and it will continue to be published after 2021.

New contracts concluded before 31 December 2021 should be revised in order to either define a reference rate other than LIBOR, or use existing fallback language that includes a clearly defined alternative reference rate after LIBOR’s. Regulators have published alternative reference rates (Risk-Free Rates, RFR) that are available to the market participants (banks, corporates, insurers, asset managers), as follows:

  • €STR (Euro Short-Term Rate) replacing EONIA, EURIBOR;
  • SONIA (Sterling Overnight Index Average) replacing GBP LIBOR;
  • SOFR (Secured Overnight Financing Rate) replacing USD LIBOR;
  • SARON (Swiss Average Rate Overnight) replacing CHF LIBOR; and
  • TONAR (Tokyo Overnight Average Rate) replacing JPY LIBOR.

This transition represents a significant change for the financial sector given its worldwide weight and complexity of implementation from the perspective of both regulators and taxpayers. One of the most important elements affecting the transition relates to the tax and transfer pricing impact of the reform.

The transfer pricing regulations in Luxembourg require multinational enterprises to comply with the arm’s length principle when it comes to their intra-group transactions. In other words, any transaction performed between related party enterprises should be priced at levels that third-party enterprises would agree to or that are applied on the market.

LIBOR rates are sometimes used in intercompany financial transactions (i.e. loans with floating rates, cash pooling arrangements, group-wide transfer pricing policies for financial transactions, etc.). While fixed interest rates will remain unchanged, the transition will affect floating interest rates applied to inter-company financial transactions. In fact, the price of the transactions that were historically linked or were relying on interbank rates will no longer have an arm’s length point of reference. Thus, it is recommended as best practice to re-assess the arm’s length rate of such transactions in order to determine the appropriate equivalents with the new RFRs.

There are two main transfer pricing challenges that the Luxembourg market participants should consider to ensure a smooth transition:

1. Structural differences between rates

There are significant differences between the RFR and LIBOR rates. The RFRs are overnight indices ,nearly risk-free rates based on actual transactions, whilst LIBORs are term rates representing average survey-based interbank rates at which the banks (representing the survey panel) could borrow. LIBOR rates are hence reflecting a perceived credit and liquidity risk inherent to the interbank market, which makes the fixings for RFRs to be lower than traditional interbank rates. In addition, the RFRs do not include term structures and thus avoid the inclusion of any longer-term lending premium. The key criticism towards the market manipulation of IBOR rates is also limited with the new RFRs given that their constructions rely on much wider transaction volumes.

The transition will also produce practical challenges in applying the adopted new rates as historical data is not always available for the new RFRs whilst data for traditional IBOR rates will soon no longer be available (e.g. backward-looking vs. forward-looking swap approach).

2. Review of existing contracts

Market participants should review their legal agreements and ensure there are robust fallback clauses included. Fallback provisions refer to the legal provisions included in a contract and determine the new reference rate/spread adjustment rate to be used by parties in the event that the initial rate is not available.

A provision simply allowing the switch from IBOR rates to RFRs may not suffice to cover the transfer pricing aspect of a transaction. Due to their essential differences, tax administrations could argue that the lower fixings could mean that a trade, which transitions from LIBOR to a RFR, has a different market value over time than it otherwise would have had. Thus, the transaction needs to be re-assessed from a transfer pricing perspective.

To conclude, it is of the utmost importance for taxpayers to assess the transfer pricing implications of the IBOR transition with regards to their intra-group transactions. Considering this reform in advance and taking the appropriate steps before the disruption of the interbank rates will help taxpayers smoothen their transition to incorporate the new RFRs in their transfer pricing policies. It is important to first assess the impact of the transition and then appraise and document the changes accordingly.

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ibor transition transfer pricing

IBOR Transition & Transfer Pricing (TP)

IBOR rates will start being phased out as from 1 January 2022.

This change presents challenges and potential business risks, including transfer pricing compliance risks.

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