The End of an Error–What Life After LIBOR Means for Transfer Pricing
Granted, when the news first broke in 2012 that traders had been manipulating the London Interbank Offered Rate (LIBOR)—submitting artificial benchmark rates as low as their own not-so-ethical standards—we didn’t exactly fall off our chairs. (Though we still aren’t happy about that extra bit of interest they added to our mortgage rates as a result.) The LIBOR was, after all, set by banks who had vested interests in the rates they reported. So, is it their fault they disclosed prices that favored their own positions—or ours, for giving them the opportunity in the first place? Wherever you land on the moral codes held by money-hungry investment bankers, one thing we can all agree on is that the LIBOR Scandal, as the catastrophe is notoriously known, has caused considerable problems–billions of dollars in fines for major banks, jail sentences for the most egregious offenders, and soon, it will lead to the end of the universal benchmark rate altogether. And most tragically, a whole lot of work for you.
That’s right. The end of LIBOR is coming. By June 2023, the universal rate tied up in roughly $340 trillion of financial contracts worldwide—everything from simple home loans to complicated derivatives—should be extinct. And for strategic transfer pricing executives (yes, of course, we mean you), the transition away from LIBOR begins now. Dealing with intercompany loans? Cash-pooling agreements? Guarantee fees? A new reference interest rate can jeopardize your arm’s length status. So, how do you embrace a base rate other than LIBOR and keep your intercompany transactions intact (not to mention, steer clear of overzealous tax authorities)? So, how can you make LIBOR’s dramatic exit a little less dramatic?
Meet the Replacement Rates. As you well know, there’s no shortage of alternative rates to LIBOR: The U.S. has introduced the Secured Overnight Financing Rate, a.k.a. SOFR. British hedge fund trades are linked to the Sterling Overnight Interbank Average Rate (SONIA); the European Union has ESTER (Euro Short-term Rate); and Switzerland is operating off of the Swiss Average Rate Overnight, (SARON). Don’t forget Canada, home to the Canadian Overnight Repo Rate Average, a.k.a. CORRA, and Australia’s the Australian Interbank Overnight Cash Rate (AONIA), and so on. The problem is that with each country introducing its own currency-specific benchmark rate (have multilateral solutions become completely obsolete?), you’ll have to understand how each new base rate not only relates to LIBOR, but also how these base rates relate to each other. In a cash-pooling agreement with say, 10 member countries and multiple currencies, well, you can see where things can get complicated.
Know where you’re vulnerable. You know the end of LIBOR is coming–so what have you done to prepare? Nothing? We thought so. Well, consider this your proverbial kick. Now’s the time to take stock of intercompany financial instruments–loans, cash-pooling arrangements, back-to-back lending agreements, and any other LIBOR-based transaction that will mature after that June 2023 deadline. Compile the information in a spreadsheet—or at the very least, in one place–and identify outstanding balances on intercompany loans. While you’re at it, take note of interest rates, base rates, and counterparty countries, so you know your lenders from your borrowers and exactly which entities stand to be affected. With critical info at your fingertips, you’ll be well equipped to strategize a transition plan.
Revise your transfer pricing policies and intercompany agreements. Yes, we know those contracts were a bear to set up the first time around, but here’s the thing: If you don’t modify them to include new timelines, new reference interest rates replacing LIBOR, and general fallback language that covers the unpredictable—i.e. “the borrower shall endeavor to establish an alternative rate of interest to the LIBOR rate,” and other boring legal jargon, then not only could your agreements be seen as invalid, putting you at a huge risk for an adjustment from tax authorities, but you’ll also need a new one. A new agreement means new everything—new dates, new loan terms, and for the borrower, a new credit analysis (gulp!). Spare yourself the trouble and amend those agreements now.
Play up the change. Like it or not, LIBOR’s swan song is now part of your transfer pricing narrative, so shout it from the hilltops, post it on Instagram, and by all means, put it in your transfer pricing report. A new benchmark rate can affect transfer pricing comparables that currently align with LIBOR, so note any changes that you’ve made to loan agreements, including adjustments to credit spreads and margins. Tax authorities may see omissions as red flags.
Keep up with new regulations. The IRS is already on the case—and presumably, soon other tax authorities will be, too. The U.S. Treasury just proposed regs to help lead you through the intricate labyrinth otherwise known as, the LIBOR phase-out. A few key points: The guidelines steer you to acceptable qualified rates (SOFR, included); require that LIBOR- and post-LIBOR-based transactions must operate at fair market value (i.e. the historic average of the old and new reference rates must be within 25 basis points); and LIBOR and post-LIBOR reference rates must refer to transactions conducted in the same currency. No-brainers, sure—but at least someone is taking the reins.
Team up with treasury. If there ever was a great time to get on the same page as your finance department, this is it. Treasury departments, after all, set up third party loans, negotiating foreign rates—which include foreign reference rates–with banks. Hint, hint, tax departments: Think internal CUPs. As for treasury, you get a front-row look at how your data is used, and most importantly, how it affects your bottom line.
For more on what the end of LIBOR means for transfer pricing, listen to Episode 27, “Life After LIBOR,” on The Fiona Show