Inevitable shift from LIBOR: The catalyst revamping inter-company financing transactions

March 19, 2020 3:39 PM

The Bank of England, Risk Free Rate Working Group and the Financial Conduct Authority (FCA) have jointly recommended Sterling Overnight Index Average Rate (SONIA) as an alternative to LIBOR.

LIBOR, SONIA, The London Interbank Offered Rate, OECD, ARR, MNE, Is UK sponsored SONIA the best alternativeMarket pulse suggests that amongst the most preferred and prospective ARRs, SONIA is emerging as the topmost alternative for the LIBOR.

The London Interbank Offered Rate (LIBOR), introduced in 1986, is the average rate of interest at which borrowings are made amongst major global banks and financial institutions. The Intercontinental Exchange (ICE) administers LIBOR and publishes the same every day. This published LIBOR serves as a globally accepted benchmark and is used by various banks, financial institutions, wealth managers and advisors, lenders and insurers.

However, the reliability placed on LIBOR has become uncertain over time, which can in some measure be traced to the banking crisis of 2017 and a reduction in the quantum of inter-bank borrowings since then. Therefore, the ICE in 2014 professed that LIBOR may not continue to serve as a reliable market yardstick beyond 2021.

On one hand, the Bank of England, Risk Free Rate Working Group and the Financial Conduct Authority (FCA) have jointly recommended Sterling Overnight Index Average Rate (SONIA) as an alternative to LIBOR. On the other hand, the Alternative Reference Rates Committee (ARRC) of the US Federal Reserve has recommended Secured Overnight Financing Rate (SOFR) as a suggested alternative. Both the working groups have also laid down the transition plan to catalyze the shift away from LIBOR. Other countries such as Switzerland and Japan have adopted their respective Alternative Reference Rates (ARR).

What is in store for Stakeholders?

The foreseeable die out of LIBOR would impact the above-mentioned market stakeholders. Over years, numerous lending/ borrowing contracts have been framed using LIBOR. Given the distinguishing characteristic of LIBOR’s stability, finding an equitable alternative would be a challenge. Even if the market settles with a robust alternative, the transition from LIBOR to any other ARR would be a cumbersome process.

New contracts may be entered with the suitable ARR. However, converting contracts bound by LIBOR that are outstanding would be an immediate challenge for the stakeholders given the operational, tax, financial and legal risks that the transition would involve.

The transition process

The authors have put together a flow chart for ease of understanding of the transition process and steps to tackle the changevover:

# Create Awareness: to begin, it is important to create awareness for the impeding shift away from LIBOR, both within and outside the company’s network, and practically reduce reliance on LIBOR;

# Circumference legacy contract: secondly, understand how to circumference legacy contracts, identify associated risks and evaluate the potential impact when the contracts will be altered;

# Frame recourse to cope up with the risks: stakeholders need to take into account the effect of moving away from LIBOR, such as any financial costs and legal implications which need to be accounted for;

# Set up transition initiatives: management needs to identity and assign senior personnel to keep themselves abreast with the market led initiatives for the changeover and set up internal governance mechanisms to oversee this change;

# Build future contracts and related documentation: engage with consultants, regulators, borrowers and lenders to determine an ARR and frame detailed documentation/ contracts binding future transactions.

The phase of transition as mentioned above would not only involve operational and legal issues, but also tax issues including transfer pricing aspects that the corporates need to evaluate in detail.

Transfer Pricing perspective

Many large multinational enterprises (MNEs) undertake inter-company financing arrangements, which are continuous in nature and have LIBOR at the base of such financing. Such transactions are highly material from a transfer pricing perspective.

The change away from LIBOR would have a rippling effects for the MNE group. Since the financing arrangements of the MNEs are largely intertwined, it is critical to evaluate the effect from the perspective of each jurisdiction involved in the transaction and its respective ARRs. Groups also have to be cognizant as to whether the interest limitation rules prescribed by each country is in line with Base Erosion and Profit Shifting (BEPS) Action Plan 4.

LIBOR had largely gained global acceptance and the blessings from revenue authorities across jurisdictions. Specifically, in India, many judicial precedents have accepted LIBOR for inter-company transactions such as inter-company loans, outstanding receivables from related parties /Associated Enterprises (AE) deemed as loan, computation of secondary adjustment, etc. However, with the need to find an alternative to LIBOR, taxpayers and the MNE at large also need to be cautious of the fate of their preferred ARRs before the revenue authorities.

This could also lead to reframing of safe harbor rules and revision of signed Advance Pricing Agreements (APA) which are valid beyond 2021. Risk of litigation is another aspect that MNEs have to factor, specially in countries like India, where the revenue authorities have always adopted contentious positions vis-à-vis inter-company financing arrangements.

Is UK sponsored SONIA the best alternative?

Market pulse suggests that amongst the most preferred and prospective ARRs, SONIA is emerging as the topmost alternative for the LIBOR.

SONIA is calculated as the weighted average rate of all unsecured overnight sterling transactions brokered in London by Wholesale Markets Brokers’ Association (WMBA). Transition to SONIA is also easy since it is already referenced in the liquid sterling market and is sustainable to the volume of transactions. Also, it is predictable and robust as it tracks the bank rate closely.

However, one cannot ignore the fact that SONIA is an overnight rate and not a term rate. MNEs usually prefer certainty to their contracts and choose to frame their contracts using term rates which provide certainty. The market players have also indicated that a forward-looking SONIA rate may be created to bridge this gap and bring more robustness to this LIBOR alternative.

Way forward

MNEs are required to plan their future contracts at this stage so as to gear up for the LIBOR shift by 2021. Having said that, in order to tackle the issue with their legacy contracts, it is suggested that they evaluate the risk at hand and design internal policies and documents to neutralize them. This could be achieved by estimating the financial costs or losses and evaluating the accounting impact of the same.

Regulatory bodies and the revenue authorities are also expected to contribute to this situation by way of coming out with required notification or circulars suggesting their most preferred ARR. Bodies like Organisation for Economic Co-operation and Development (OECD) may prescribe guidelines to benchmark the inter-company financials transactions and indicate what would be the characteristics of the most preferred arm’s length price.

While at this juncture, major markets have resorted to different ARRs, SONIA still emerges as the closest substitute to LIBOR. However, the practical use and acceptability of SONIA or for that matter any other ARR would need to withstand the test of time. Where on one hand, every MNE is trying to establish certainty in respect of their inter-company transactions, the expiry of LIBOR may lead to unexpected hardships. However, robust planning at an early stage may help eliminate and moderate many foreseeable challenges.

(By Gaurav Jain, CA, Director in a large tax consultancy firm; and Priya Mani Bhutani, CA, Associate Director)

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