KPMG report: LIBOR transition, transfer pricing considerations of intercompany financial arrangements

Potential effects of transition on arm’s length nature of intercompany financial transactions

Transfer pricing considerations of intercompany financial arrangements

A transition is taking place throughout the world from interbank offered rates (IBORs) to alternative benchmarks. At the end of 2021, LIBOR (London Interbank Offered Rate)—a reference point used globally for variable interest rates charged on financial products—will mostly no longer be available.

As businesses begin to adapt their external financial arrangements to a world without LIBOR, they may also need to consider the potential effects this fundamental change could have on the arm’s length nature of their intercompany financial transactions—that is, evaluate possible transfer pricing considerations given the LIBOR transition.

Background

Over time, the IBORs will have to be replaced with an alternative system for determining the base component in variable interest rates. The alternative for the IBORs is expected to be several other government-sanctioned benchmarks for a risk‑free rate. These benchmarks will be used for a wide variety of contractual arrangements and financial instruments containing variable interest rates.

The IBOR transition was initiated as a policy response to two developments.

  • First, a number of traditional interest-rate benchmarks, notably LIBOR, were affected by market manipulations that severely undermined their integrity.
  • Second, the underlying market for unsecured interbank funding experienced a marked decrease in transactions—and continues to do so—eroding the degree to which IBORs represent the funding costs of financial institutions.

The IBOR transition will not only have an effect on financial markets, as such, but may also have an effect on the intercompany pricing of loans, which often also make use of IBOR rates as a variable interest component.

Transfer pricing considerations

Businesses adapting their external financial arrangements from LIBOR-based transactions also need to consider the potential effects of this change on the arm’s length nature of their intercompany financial transactions.

Replacing LIBOR will require companies to evaluate the current LIBOR-based variable interest rate pricing on intercompany transactions. Situations may arise when intercompany financial transactions are based on LIBOR rates that have already been phased out. Companies will therefore need to consider alternative base rates to replace LIBOR in the future. These alternative benchmarks may require the application of an “arm’s length spread” on intercompany financial transactions, so that neither party to the transaction is disadvantaged.

Following the announcement that LIBOR would be discontinued, alternative risk‑free rates have been introduced for various currencies, such as:

  • Secured overnight financing rate (SOFR) for the U.S. dollar
  • The sterling overnight index average (SONIA) for the UK pound
  • The Tokyo overnight average rate (TONAR) for the Japanese yen
  • The Swiss average rate overnight (SARON) for the Swiss franc
  • Euro short‐term rate (€STR) for the euro (replacing EONIA) (EURIBOR also remains in effect).

The alternative risk‑free rates are mostly published as overnight rates. This is a significant change compared to the LIBOR rates that are published in various terms (e.g., one-month, three-months, etc.). In order to account for the different terms of the alternative risk‑free rates compared to the LIBOR, an analysis will need to be carried out to assess any transfer pricing effect.

Companies will also need to confirm that the changes are supported by contractual clauses in both new and existing agreements. To the extent LIBOR is referenced in existing agreements, appropriate fallback language may need to be included.  However, companies must, when possible, avoid making changes that are so substantive that tax authorities could argue that a new loan has been issued—rather than an existing loan having been changed.

From a transfer pricing perspective, related parties are to transact with one another in the same way as unrelated parties would under similar facts and circumstances. Therefore, it is useful to also look at relevant industry practices.

Various industry associations—such as ISDA (International Swaps and Derivatives Association) and the Loan Markets Association (LMA)—have developed standard fallback texts for the IBOR transition. The EU Working Group has also prepared a general fallback text [PDF 769 KB] that can be used, but that may have to be customized to reflect the particular needs of a contract. 

KPMG observation

Given the scope of the implications of the LIBOR phase-out, it is important for affected companies to manage this transition carefully and to account for any differences between the two rates (i.e., LIBOR and new risk‑free rates).

A first step is for companies to identify intercompany agreements containing LIBOR references and modify those agreements. Once the affected agreements are identified, companies need to consider developing a plan to adjust the pricing of their affected arrangements so that these are ready once LIBOR is discontinued.

With about three months remaining before LIBOR is discontinued, being proactive now could help to mitigate or prevent any future disputes.

Read a September 2021 report prepared by the KPMG member firm in the Netherlands

 

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