Benchmarking rates: Alternatives to LIBOR

Benchmarking rates: Alternatives to LIBOR

LIBOR (London Interbank Offer Rate) has often been used by Multinational Enterprises (MNEs) in their inter-company cross border financial transactions like loans, deposits, cash pooling transactions etc. For more than three decades it has been serving as the standard point of reference for various debt instruments.

From a Transfer Pricing (TP) perspective, loans given by holding companies to subsidiaries and vice versa are considered as international transactions and prevailing market rates are considered for these type of transactions to be at arm’s length. These loans are in foreign currency like USD/GBP/Euro and accordingly, Euribor/ Libor rates are used as base rates along with spread for benchmarking.

The global financial crisis made regulators uncover explicit manipulations by banks to influence rate-fixing with the intent of projecting financial soundness during the crisis and benefitting proprietary trading positions. It was in July 2017, the FCA (Financial Conduct Authority) declared it would no longer compel panel banks to submit the rates which are required to calculate LIBOR. There is a collaborative effort underway on the part of international policymakers to reform the reference rate.

On 5 March 2021, the FCA and the ICE Benchmarking Administration (IBA) announced the end dates of the LIBOR. As per it, the publication of all Euro and Swiss Franc, most Sterling and Japanese Yen as well as the one-week and two-month US Dollar-LIBORs will be ceased immediately after December 31, 2021. The publication for remaining US Dollar-LIBORs is intended until June 30, 2023, while the publication of remaining rates for Japanese Yen and Sterling after the end of 2021 for one additional year.

In the Indian context, the RBI issued a notice to banks and other RBI-regulated entities, emphasising the need to speed up the transition away from LIBOR. The RBI notice stated that banks and financial institutions should not enter any new LIBOR related contracts after December 31, 2021.

Currently, the abolition of LIBOR has become challenging from a TP perspective as this transition will lead to switching to alternate Risk-Free Rates (RFR) causing significant market disruptions. Neither the Indian TP regulation nor the India tax office has issued any guidelines as to what the benchmark rate should be. However, Secured Overnight Financing Rate (SOFR) and Sterling Overnight Interbank Average Rate (SONIA) are the two popular alternatives available. The Singapore Overnight Rate Average (SORA) is also a new addition.

Challenges of new rates

(i) Unsettling the settled position — From a TP perspective, this transition will have considerable impact as such financial agreements do not contain a fallback provision specifying adjustments necessary to transition away from LIBOR.

As everything was settled based on LIBOR, currently there is not much clarity on the benchmarking rate. In the absence of any guidance from tax authorities, they may argue that the adjustment of the reference rate constitutes a significant modification of the existing financial contract. In such cases, the relevant terms and conditions of the inter-company agreement would also have to be renegotiated which may lead to a reframing of safe harbour rules and revision of the Advance Pricing Agreements (APA) which are valid beyond 2021.

(ii) Existence of current agreements with floating rates — The existence of the current agreements with floating rates becomes doubtful. The agreement needs to be updated/changed from the existing rate to a new rate. There is no clarity on whether this change needs to be on a prospective or retrospective basis.

(iii) Possible impact of the faceless assessment regime in India — The risk of litigation and a detailed explanation about the change of the existing rates becomes even more challenging as we are getting into the world of faceless assessment.

The way forward

(i) Review of inter-company agreement, if ARR is applied and the ARR rates selected may be considered as close as possible to the originally agreed rates.

(ii) Mindful of the complexities involved in such financial transactions coupled with the impending faceless assessment regime. Accordingly, robust documentation along with detailed benchmarking and backup working should be maintained to aid in explaining the position to the tax office if challenged.

Any change in a settled practice that was established over decades would result in initial challenges, not only from a financial market perspective but also from a TP perspective. Such a change should be embraced with a pragmatic mindset based on facts. Seamless transition and appropriate documentation hold the key.