The London Interbank Offered Rate (LIBOR) serves as a global benchmark for financial transactions with an estimated volume of USD 370 trillion. The discontinuation of LIBOR at the end of 2021 will require market participants to use alternative key interest rates from 1 January 2022 at the latest.
LIBOR is an interest rate based on the average reported interest rate at which the major global banks can borrow unsecured. It is published for five currencies with different maturities. LIBOR is used to price many types of financial products, from plain vanilla loans to interest rate swaps and other complex derivatives.
This change also has an impact on the transfer pricing systems of multinational enterprises ("MNEs") that have entered into intercompany financing arrangements based on LIBOR. Affected entities should assess the impact on existing transactions and policies in a timely manner and prepare a transition scenario that considers the likely impact of the discontinuation of LIBOR.
Alternatives to LIBOR
Alternative interest rates have emerged in various countries, but their characteristics differ considerably from LIBOR depending on the region, currency, term and basis.
In the USA the Federal Reserve introduced in 2018 is establishing itself Secured Overnight Financing Rate (SOFR). SOFR is based on the interest rate for banks borrowing overnight in the market for repurchase agreements, where lenders such as money market funds make short-term loans to bond brokers, often using government bonds as collateral. The alternatives in the UK, the Reformed Sterling Overnight Index Average (SONIA) and in Europe, the Euro Short-Term Rate (ESTER) are unsecured instalments. The Swiss average rate (SARON), a rate secured overnight, is based on a mixture of transaction and survey data.
Possible alternatives to the various LIBOR rates are
Companies that price intragroup financing transactions or have financing structures (e.g. in-house banks, cash pools and back-to-back loan agreements) that are based on LIBOR must switch to an alternative interest rate from 1 January 2022 at the latest.
Effects on transfer prices
Intercompany loans
For intercompany loans that use LIBOR as the base rate and that fall due after 2021, an amendment to the agreements should be considered in good time and any necessary measures and timetables for the changeover should be added.
It should be borne in mind that in the USA, for example, certain changes may be regarded as tax-deductible and possibly trigger a taxable gain or loss or affect an interest deduction restriction.
Companies that conclude new intercompany loans by the end of 2021 should consider including fall-back clauses.
Transfer pricing policy
According to the generally applicable transfer pricing standards, intragroup loans must be agreed at arm's length in order to avoid tax disadvantages. The information contained in LIBOR and the proposed new reference interest rates may differ to a greater or lesser extent in terms of their comparability. Companies should therefore review their transfer pricing policy at this point, reassess it if necessary and redefine rules on comparability.
IT systems and processes
Changing a transfer pricing policy usually has an impact on IT systems and processes for calculating intercompany interest rates. Depending on the degree of automation, this may require reprogramming and updating of ERP systems.
Necessary measures range from process manuals to training for finance and/or tax teams that work operationally with transfer pricing.
Companies that use labour-intensive processes to manage intercompany financing or their liquidity should realign existing models and determine the sources from which market information will be retrieved in the future. Appropriate adjustments and conversions may need to be made in line with new guidelines. Coordination between Finance, Controlling, Tax, Transfer Pricing, Treasury, Legal and IT is strongly recommended.
Hedging transactions
MNEs often conclude hedging transactions as part of their risk management in order to limit currency risks. These are often linked to LIBOR. Treasury departments and house banks should therefore plan for the impact of the discontinuation of LIBOR on existing intercompany financing and hedging structures.
Recommendation
Although there is still some time until the end of 2021, the impact of the discontinuation of LIBOR on a transfer pricing policy requires careful analysis and planning of the adjustments. To enable a smooth transition, the affected transactions and structures should be identified in good time and transition scenarios developed to adequately address the abolition of LIBOR.
Carsten Schmid is a transfer pricing expert and will be happy to provide you with further information in this area.
