IBOR reform - time to check the tax impact
Tax Alert - October 2021
By Sam Kettle, Troy Andrews, Will Dawson & Bart de Gouw
Interbank Offered Rate (IBOR) reform is one of the most significant undertakings in the financial services industry in recent years. The resulting potential changes to affected contracts could have a variety of tax impacts, so it’s important as part of the review process to ensure those tax impacts are properly understood and reflected in the updated agreements, if relevant, and in related tax filings. IBORs, especially the LIBOR, have set the benchmark rate for lending on an unsecured basis, underpinning the worldwide trade in financial products. However, a series of scandals surrounding LIBOR during the last financial crisis and sustainability concerns in the unsecured banking market led regulators around the world to look into alternative risk-free reference rates (RFRs).
The UK’s Financial Conduct Authority (FCA) announced earlier this year that from 31 December 2021, all GBP, EUR, CHF, and JPY LIBOR settings in all tenors (overnight, one week, and one, two, three, six, and 12 month settings), and USD LIBOR one week and two month settings either will cease to be provided by any administrator or will no longer be representative. USD LIBOR overnight and one, three, six, and 12-month settings will cease on 30 June 2023.
Accordingly, businesses may be looking to make changes to the contracts of impacted IBOR-based financial products by:
- replacing the existing IBOR in the relevant agreement with an alternative RFR.
- amending existing fallback clauses or introducing fallback clauses where they do not currently exist.
- making other variations to contracts as a direct consequence of IBOR reform, such as additional payments to be made for the purposes of preserving the parties' economic positions.
For different stakeholders, any variation to the financial contract must be carefully analysed to determine whether it amounts to:
- the modification of an existing contract (i.e. a continuation of the existing contract); or
- the termination of the existing contract replaced by a new contract.
These changes are likely to impact cash flows, financial reporting and tax, among other things. The affected entities should conduct impact assessments, design change solutions, plan the transition and implementation of the new RFRs.
New Zealand income tax considerations
While the Australian Tax Office (“ATO”) has recently released a consultation paper surrounding the reform acknowledging there are likely to be challenging tax implications, Inland Revenue is yet to follow. The tax considerations contained in the ATO’s consultation paper are broadly consistent with what we would consider in New Zealand.
Financial arrangement rules
The key consideration from a New Zealand tax perspective is whether a Base Price Adjustment (BPA) would be triggered under the financial arrangement rules. A BPA, which is a wash up calculation bringing all consideration under the arrangement to tax, is required when a financial arrangement matures – i.e. if there is a termination or extinguishment of the existing contract. This is a different analysis to the methodology that will be applied under IFRS 9 for accounting purposes, and so it may be the case that there are differences between tax and accounting that need to be understood.
Where the changes to the contract are regarded as a modification of the existing contract (such as where the existing fallback clauses are modified) Determination G25 (Variations in the Terms of a Financial Arrangement) may need to be considered by some taxpayers (especially those not applying the IFRS method). Under this Determination, the total accumulated income or expenditure up to the end of the year of variation is equal to the amount that would have been subject to tax had the changes been known at the date of issue or acquisition. In other words, the life-to-date income or expenditure is reset treating the new terms as if they applied from the inception.
Most entities that have any transfer pricing arrangements will need to consider the effect of the cessation of IBOR. If IBOR has been used as a reference rate, the cessation could result in financial contracts with related parties needing to be re-drafted to include a new RFR. Further consideration will need to be given to how the rate is adjusted and what the consequences of those adjustments are in the context of New Zealand’s transfer pricing framework. Questions could include: is the all-in interest rate still considered to be at an arm’s length rate or is one party now receiving a benefit from the cessation of LIBOR and transition to a more/less risky base rate? It will be important to observe how the market reacts to the transition, and whether lenders/borrowers are seeking to renegotiate risk premiums in loan agreements that had previously relied on an IBOR as the base rate. Further, in relation to the fallback provisions that are encouraged to be negotiated into financial contracts – are these considered to be at arm’s length?
In addition, it will be necessary to consider the restricted transfer pricing (“RTP”) implications and whether a change in base rate constitutes a “renegotiation” for RTP purposes. If a loan is renegotiated, then the RTP rules would require determination as to whether the borrower is a high BEPS risk borrower on that day. For loans that have been in place since before the introduction of the RTP and revised thin capitalisation rules, that may result in loans being classed as being “high BEPS risk” when they previously were not. Additionally, the determination of deductible interest is required to be undertaken as at the day of renegotiation. In the current interest rate environment that may result in a reduction of the deductible amount of interest.
Deductibility of associated costs
For any costs that fall outside the scope of the financial arrangement rules (such as non-integral fees in IFRS terms), the deductibility needs to be considered under the DA 1 general provisions or, if the capital limitation is at play, under section DB 5. The analysis under DB 5 can be far from straight forward. The Commissioner’s view (as expressed in the Interpretation Statement IS 13/03 Income Tax – Deductibility of Expenditure Incurred in Borrowing Money – Section DB 5) is that expenditure must be incurred in establishing or setting up the borrowing in order for the expenditure to be deductible under section DB 5. The Commissioner has explicitly added that costs associated with a variation of the existing loan that does not result in the rescission of the original loan contract and the establishment of a new one will not be deductible under section DB 5.
Withholding tax obligations
If any payment is made to preserve the economic positions of parties to a financial arrangement following an amendment to replace an IBOR rate, withholding tax obligations should be considered. The tax impact will depend on the source and character of the payment, the nature of the underlying contract, and the party making the payment (e.g., if a borrower is required to pay an amount to a lender, the payment could be in the nature of interest on money lent, whereas a payment from a lender to a borrower would be unlikely to be in the nature of interest).
If you have any financial contracts referencing IBORs, the financial reporting and tax implications must be considered and, to the extent possible, feed into the negotiation process to achieve an optimal outcome. If you require any assistance, please contact the Deloitte team.
October 2021 Tax Alert contents
- Something for everyone in the new tax bill
- GST reforms: GST is moving into the digital age and other remedials proposed
- Property tax details revealed
- Tax rules are catching up with cryptoassets
- New FBT rate option announced – but how helpful is it?
- COVID-19 Updates – October 2021
- Tax Governance: Inland Revenue’s latest compliance campaign
- Economic income and tax on a collision course? Inland Revenue’s effective tax rate project is about to start
- IBOR reform - time to check the tax impact
- Snapshot of recent developments