Interbank offered rate reform has been saved
Interbank offered rate reform
Key tax, accounting and legal considerations
Published: 07 September 2022
Interest rate benchmarks such as interbank offered rates (IBORs) play a key role in global financial markets and are widely used with financial products such as derivatives and loans. However, work is underway in multiple jurisdictions to transition to alternative risk-free rates (RFRs). Several reasons have driven this move, including -
- systemic risk concerns have been raised due to instances of fraud and underlying markets not being sufficiently active for some of the IBORs, together with the key reliance of financial transactions on these rates.
- panel banks that contribute IBOR information are less comfortable providing those submissions when the volume of underlying transactions is low, due to potential litigation risks.
These factors could lead to rate manipulation and increasing concern over the appropriateness of these rates especially in stressed market conditions.
Alternative RFRs were selected, by Financial Stability Board (FSB) working groups, in key currency jurisdictions, with the objective that such rates will be based on liquid underlying market transactions, as opposed to depending on submissions based on judgement. Alternative RFRs will increase reliability for products and transactions that do not need to incorporate a credit risk premium. This has led to uncertainty about the long-term viability of some existing interest rate benchmarks.
The London Interbank Offered Rate (LIBOR) is the average interbank interest rate at which panel banks on the London money market are prepared to lend to one another, on a secured basis. It is calculated by the ICE Benchmark Administration Limited (IBA)1 and published on each working day at 11.55am GMT by Thomson Reuters. It is produced for five currencies (GBP, USD, EUR, CHF, JPY) and seven tenors (overnight/spot next, 1 week, 1 month, 2 months, 3 months, 6 months and 12 months). Up to 16 panel banks for each currency submit their rates based on transactions, transaction derived data and expert judgement. The published rate is the trimmed mean of the individual submissions. The benchmark rates vulnerability revealed in the wake of the 2012 LIBOR scandal signalled the beginning of the benchmark reform globally. The interest rate benchmark LIBOR ceased in two phases from the end of 2021 and therefore other alternative rates must now be considered. This transition may give rise to tax, accounting and legal consequences that should be considered. These consequences are discussed below.
IBOR reform: A financial reporting perspective
IBOR reform: A financial reporting perspective
The International Accounting Standards Board (IASB) identified two groups of accounting issues related to the IBOR reform that could impact financial reporting:
• pre-replacement issues – these are issues affecting the accounting in the period before the terms of the financial instruments are modified (Phase 1)2; and
• replacement issues – these are issues that might affect the accounting when an existing interest rate benchmark is actually either reformed or replaced (Phase 2)3
We have provided a brief, simplified summary of the key amendments to the accounting standards arising from the IBOR reform below.
The hase 1 amendments only affect entities that apply hedge accounting (under IFRS 9 or IAS 39) to hedging relationships directly affected by the IBOR reform. A hedging relationship is directly affected only if the IBOR reform gives rise to uncertainties about:
• a contractually or non-contractually specified interest rate benchmark that has been designated as a hedged risk; and/or
• the timing or the amount of IBOR-based cash flows of the hedged item or the hedging instrument.
These amendments provide temporary relief from applying specific hedge accounting requirements to affected hedging relationships. The reliefs have the effect that IBOR reform should not generally cause hedge accounting to terminate during this phase. However, any hedge ineffectiveness should continue to be recorded in the income statement.
The Phase 1 amendments additionally introduce further disclosure requirements to be considered by the preparers of financial statements.
The Phase 2 amendments address issues that might affect the accounting application during the reform of an interest rate benchmark.
The amendments are pervasive and will affect many entities. Some of the key Phase 2 amendments are briefly summarised below. More detailed guidance on the accounting amendments can be sourced from topic-specific Deloitte publications.
Changes in the basis for determining the contractual cash flows as a result of IBOR reform under IFRS 9
The amendments provide specific guidance on how to treat financial assets and financial liabilities where the basis for determining the contractual cash flows changes as a result of the IBOR reform. This can include:
• cases where the contractual terms are amended;
• cases where the contractual terms are not amended but, for example, where the method for calculating the interest rate benchmark is altered (i.e. where the benchmark interest rate is changed) ; and
• cases where an existing contractual term is activated such as when a fallback clause is triggered.
As a practical expedient, the amendments require an entity to apply IFRS 9:B5.4.5, such that the change in the basis for determining the contractual cash flows is applied prospectively by revising the effective interest rate. This practical expedient only applies when the change in the basis for determining the contractual cash flows is necessary as a direct consequence of IBOR reform and the new basis for determining the contractual cash flows is economically equivalent to the previous basis.
When multiple changes are made to a financial asset or a financial liability, the entity first applies the practical expedient in IFRS 9:B5.4.5 (explained above) to those changes required by the IBOR reform. The applicable requirements of IFRS 9 are then applied to any other changes. For example, if the basis of interest of a financial liability is changed from a benchmark interest rate to a new alternative benchmark interest rate, that change is in the scope of the practical expedient (i.e. IFRS 9:B5.4.5). Any other changes to the contractual terms that are not necessary as a direct consequence of the IBOR reform are not subject to the practical expedient and the appropriate accounting treatment is determined by applying the existing IFRS 9 requirements.
Hedge accounting under IFRS 9 and IAS 39
The Phase 2 amendments also allow a series of exemptions from the strict rules around hedge accounting.
For example, an entity will not need to discontinue existing hedging relationships because of changes to hedge documentation required solely by the IBOR reform. Therefore, when a hedged risk changes due to benchmark reform, an entity is permitted to update the corresponding hedge designation and hedge documentation to reflect the new benchmark rate and the hedge may be able to continue without interruption.
Minor amendments were also introduced to other accounting standards as a result of the IBOR reform, including IFRS 16 (standard dealing with the accounting of leases) and IFRS 4 (standard dealing with the accounting for insurance contracts).
It is important to note that the potential accounting impacts arising from the IBOR reform may be extended across various standards (and not just to those standards identified above and to which specific amendments were introduced by the IASB). For example, the IBOR reform:
• highlights the need to carefully consider the nature and appropriateness of valuation inputs used for fair value measurements in terms of IFRS 13 (e.g. the liquidity of market inputs used in valuations may change as the use of RFRs in market transactions increase over time);
• may change the level allocation of fair value measurements in the fair value hierarchy in accordance with the IFRS 13;
• will have an impact on the determination of discount rates used in valuations required by various accounting standards (e.g. impairment assessments, share-based payment valuations, provisions, environmental rehabilitation liabilities, to name a few); and
• may require the reassessment of the classification and measurement basis of financial assets and financial liabilities in terms of IFRS 9.
Contracts may include fallback terms setting out what will happen when the IBOR Reference Rate is not available. This is particularly important when looking at new financial instruments which mature beyond the end of 2021, either basing those on alternative near risk free rates (AFR) or building in a clear and robust fallback mechanism to apply once IBOR rates are no longer available. For existing financial instruments which mature after the end of 2021 incorporating such fall backs and seeking to amend those instruments to use an AFR in good time is imperative.
Commercially, there are certain challenges arising from the fact that IBOR and the AFR are fundamentally different rates, the implication of which will need to be carefully considered before transitioning, to understand the risk of value moving between counterparties. As is the case with many commercial transactions, care needs to be taken regarding the tax implications. As a result of the fluidity of the new rates, a specific analysis will need to be conducted of the potential impact of the transition as there is no one size fits all model that can be applied.
It is therefore imperative that taxpayers work through the legal and accounting implications in each jurisdiction and the consequent tax analysis to determine whether there could be any significant consequences resulting from the transition (whether through amendment of existing contracts, the operation of existing fall-back mechanisms within those contracts, or the cessation of existing contracts and the entry into replacements). Generally, and by no means all inclusive, the following consequences can arise if contracts are not adequately dealt with:
i. transitioning contracts result in a disposal of the existing contract for tax purposes;
ii. amending, or terminating and replacing, contracts result in the recognition of profits or losses for accounting purposes;
iii.any changes in contracts could result in the discontinuance of historic tax treatments (e.g. Positions agreed with local tax authorities, or legislation which only applies to contracts entered into before a particular date).
We suggest the following legal approach to dealing with the change in the reference rate:
i. review all legal agreements to determine whether those potentially affected contain a fall-back clause, stating the position in the event of an unavailable reference rate. If there is a fall-back clause, determine whether the position will be acceptable or needs to be amended. (Note that both third party and intra-group agreements will need to be carefully considered);
ii. consider whether any action is to be taken; and
iii. where action is required, determine the exact action to be taken and the implication thereof (tax indemnities or redemption clauses). It is imperative to consider the consequences of the action to be taken having a holistic approach in terms of both tax and accounting.
From a corporate tax perspective, there are two aspects to consider as a result of the transition from IBOR to AFRs, namely the tax treatment of the credit spread and whether the variation/termination of the contracts would trigger tax. In particular, could this be a disposal for capital gain tax (CGT) purposes.
Tax treatment of the credit spread4
The starting point is whether the credit spread will be regarded as interest for purposes of the Income Tax Act. If this is the case, the methodology outlined in section 24J of the Income Tax Act (ITA) regarding the incurral and accrual of interest will apply. From a cross border perspective, the classification is important in determining which of the source rules are applicable. Would section 9(2)(b) which refers to the section 24J interest definition be applicable or does one need to look at the more elaborate common law principles from the Lever Bros case (i.e. originating cause).
Turning to the interest definition, which is outlined in 24J, paragraph (a) and paragraph (b) of the interest definition are relevant. In terms of paragraph (a), interest is defined as the gross amount of any interest or similar finance charges, discounts or premium payable or receivable in respect of a financial arrangement.
The interest definition is circular, therefore one has to consider the judicial decisions which interpreted the term. There are a number of judicial decisions, however they all seem to adopt the same interpretation (although expressed in different words) which is essentially “interest is an expense to compensate a lender for the time period during which the money is lent to the borrower”.
Looking at that definition in terms of the credit spread. Credit spread is paid to compensate the lender for the lower rate of interest that it would otherwise receive as a result of a move to AFR (top up payment). The credit spread is to ensure that the parties remain in the same cash flow position had the change not occurred. Therefore, based on the definitions outlined by the courts, there is a good argument that the credit spread will be regarded as interest.
Paragraph (b) of the interest definition provides that amount (or portion thereof) payable by a borrower to the lender in terms of any lending arrangement as represents compensation for any amount to which the lender would, but for such lending arrangement, have been entitled. Therefore, an amount that is regarded as compensation for the lender in a lending arrangement as defined would be regarded as interest.
A covered person is defined in section 24JB and typically includes banks, company members of the JSE and hedge funds. Section 24JB introduces the concept of fair value taxation of financial instruments, such as debt instruments, interest-rate agreements and option contracts, and imports IFRS into the ITA.
The essence of the provisions requires covered persons to include in or deduct from income, amounts in respect of financial assets and liabilities based on the profit recognized on those instruments through the profit and loss statement in terms of IFRS 9. Effectively, 24JB alters the timing of the imposition of tax on gains and losses on financial instruments from realization/cashflow basis to an unrealized/paper profit basis which is taxed annually
Therefore, since the application of section 24JB is reliant on the IFRS 9 treatment of the financial instruments, any amendments/impact to the accounting treatment in terms of IFRS 9 will potentially have a tax impact.
As mentioned previously, the IFRS amendments would need to be taken into account for 24JB purposes. This is particularly true on the hedge accounting front and the potential implications highlighted above. However, in light of the IFRS amendments which provide for the period when the replacement for IBOR is unknown, one should assume that the interest rate benchmark used by an instrument will not be altered as a result of the withdrawal. Therefore, to the extent that the IFRS treatment maintains a status quo, there should be no adverse impact from a section 24JB perspective.
Tax treatment on variation of the contracts
Consideration should be given as to whether the amendment of the rate be regarded as a trigger for tax and in particular, whether this could this be considered a disposal for CGT purposes. Paragraph 11 of the Eighth Schedule provides that a disposal includes an act/event that results in the variation or extinction of an asset.
The term asset includes a right or interest in property (which includes movable, immovable, corporeal or incorporeal). Therefore, the right to receive interest by the lender will be regarded as an asset for CGT purposes. That right has a value (Brummeria case), which needs to be determined on a case-by-case basis.
The question, therefore, is whether the transition from IBOR to an AFR will be regarded as a variation in the context of the Eighth Schedule. The CGT guide provides that the word ‘variation’ must be interpreted in the context of the disposal of an asset. The principle underlying Paragraph 11 is that a person must have disposed of an asset in the sense of having parted with the whole or a portion of it. In our view, it is unlikely that the variation will be regarded as a disposal for CGT purposes as the lender still retains the right to earn interest.
In a strict sense, there may be scope to argue that, as a result of the variation, the lender has disposed of its right to receive interest equal to the difference between the IBOR rate and the AFR in return for the credit spread (i.e. a partial disposal of the right to receive interest). The question would be then, how would one value the portion of the right given up to determine the base cost? This is likely to be determined on a case by case.
At this stage, the South African Revenue Service has not released any guidance on the tax considerations to be taken into account upon the transition and as far as we are aware, there is not anything in the pipeline as yet.
In South Africa, derivatives and loans (provision of credit) are regarded as financial services and are exempt from VAT, unless they may be zero rated (i.e. where the counterparty is a non-resident).
It is not expected that any of the amendments described above will have a VAT effect on the basis that these occurrences do not amount to a realisation of the transaction (except for perhaps the compression and conversion occurrence which would be exempt or zero rated if these are regarded as being realised as financial services).
The arrangement is that the payment is made to put the lender/borrower in the same position that it would have been had the transition not occurred, it is likely that the payment will be regarded as an adjustment to the underlying supply in view of the contractual change. This would mean that the adjustment would either be taxable or exempt depending on the nature of the underlying instrument. For example, whilst derivatives and loans are exempt, operating leases and rental agreements are taxable.
However, there is a possibility that the once off payment is made to compensate that party to accepting the amendment to the contract which may constitute a separate service. This would mean that the once off payment is for services rendered and therefore taxable (in the absence of an exemption that applies) if such supply is in the course and furtherance of an enterprise.
By way of an example. If one consider a foreign supplier and local recipient (assuming a loan from the foreign supplier):
a. Payment to foreign supplier: The recipient is benefitting from the change and therefore compensates the supplier (the parties pay/receive compensation as a result of the change to the contract). Where the supply is by a non-VAT registered supplier then the payment should not attract VAT. The local recipient would need to determine whether it is required to declare VAT on imported services (reverse charge VAT). This obligation for the recipient would not arise where the principal supplies would have been exempt if supplied in South Africa, however where it would be regarded as a separate taxable service if supplied in South Africa, imported services VAT will be payable to the extent that the service is used or consumed in South Africa for non-taxable purposes.
b. Payment by foreign supplier: The local recipient is receiving the payment as a result of a change to the underlying contract (the parties pay/receive compensation as a result of the change to the contract). If the local recipient is registered for VAT, it makes a taxable supply (i.e. allowing the supplier to change the contract which will entitle the supplier to charge more). The supply may the zero rated if all the requirements are met.
It is important to consider the potential transfer pricing consequences before implementing amendments to existing related party financial transactions. The IBOR and alternative reference rate indices reflect different levels of interest rate, due to the fact that the IBOR includes a built in credit risk element whereas the alternative reference rates do not. As a result, interest rates on loans based upon the existing IBORs will be slightly higher and therefore will need to be repriced to reflect an alternative base rate. These adjustments should consider the revised terms of the loan and the market cost of converting a given loan from IBOR to an alternative rate. The transformation effects existing and new financial products alike that range from derivatives, securitisations, mortgages, loans and bonds and floating rate notes.
Also, the revised terms of the loans will need to be considered with reference to the final version of the Transfer Pricing Guidance on Financial Transactions, which was first published in February 2020 and now incorporated into the 2022 version of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), as well as our South African thin capitalisation and new interest limitation rules. Further, to the extent that existing contracts are amended, consideration needs to be given as to whether this change will constitute a business restructuring as per Chapter IX of the OECD Guidelines, meaning that the relevant parties may have to be compensated at arm's length, to the extent that such termination and/or substantial renegotiation would be compensated between independent parties in comparable circumstances.
Therefore, it is important that existing contracts should contain suitable fallback provisions that have been appropriately considered in order to avoid adverse tax and transfer pricing consequences. Long-term funding contracts based on IBOR (which extend beyond 2021 and 2023 for GBP and USD LIBOR, respectively) should already take the transition into account. Group entities should also be aware that there may be complexities in benchmarking the new interest rates or performing comparability adjustments to new external rates, taking into account the differing credit risk components and term structures. Transfer pricing documentation and treasury policy documents will therefore need to be carefully updated for these changes in order to avoid queries from tax authorities. Groups should allow sufficient time in their compliance process in order to complete this additional work. The International Swaps and Derivatives Association (ISDA) published fallback rate adjustments that arise from the key adjustments necessary to apply alternative rate fallbacks to existing IBOR contracts. Furthermore, Bloomberg offers proxy fallback support for some of the IBOR based interest rate swap curves and is also assisting companies in various industries to confirm their securities exposure and fallback provisions.
Consideration should also be given as to whether this change will have an impact on the functional characterisation of intra-group Treasury functions. To the extent that differences arise between the terms and timing of related-party and third-party financial arrangements, a treasury function may assume risk that either needs to be managed or accepted.
In summary, before amending existing financial contracts, companies should consider whether this could:
• give rise to a disposal of the existing contract for tax and transfer pricing purposes;
• result in amendments of the principal amounts under consideration;
• require one-off compensation payments in relation to the changes, in line with Chapter IX of the OECD Guidelines;
• require a review of existing financial products/contracts for legacy products/contracts - strategy must be determined for how to deal with the credit risk adjustment to avoid a potential valuation impact;
• impact on the effective margins earned by the lender, and this require the parties to be able to demonstrate the arm’s length nature thereof; and
• impact on the functionality of existing business units/treasury functions within an organisation.
The diverse implications of the IBOR reform could potentially impact many aspects of a business. It is therefore imperative that urgent attention be afforded to any qualifying transactions in order to assess whether there will be any potential consequences of the IBOR reform and that any necessary changes are made to legal agreements and other documents underpinning the underlying transaction.
1 The administrator for LIBOR
2 In September 2019 the IASB published “Interest Rate Benchmark Reform (Amendments to IFRS 9, IAS 39 and IFRS 7)”, The amendments are mandatory and effective for annual periods beginning on or after 1 January 2020
3 In August 2020, the IASB issued Interest Rate Benchmark Reform—Phase 2 which amends IFRS 9, 7, 4, 16 and IAS 39. The amendments are mandatory and effective for annual periods beginning on or after 1 January 2021
4 In August 2020, the IASB issued Interest Rate Benchmark Reform—Phase 2 which amends IFRS 9, 7, 4, 16 and IAS 39. The amendments are mandatory and effective for annual periods beginning on or after 1 January 2021