Since Libor for the US expires in exactly one year, businesses must make sure that any alternative benchmark rate is taken into account in their TP studies and approved by tax authorities.
Before the US dollar London interbank offered rate expires in June 2023, corporations must update their transfer pricing studies as risk-free rates gain traction. Otherwise, they run the risk of encountering inconsistencies between their legal agreements and transactions.
According to Rachit Agarwal, TP director at the London-based law firm DLA Piper, "The base rate used to price arrangements is going to change, which will impact the pricing.There are certain hedging strategies that treasuries use that will need to be amended as well."
The TP teams will need to examine their historical transactions to determine which ones contain the benchmark rate. Revisions to intra-group arrangements are required.
Agarwal continues, "It’s about ensuring there is a small transition.In any loan, there are two parties. If Libor was, for example, 2%, so the lender was expecting 2%, and then Libor got replaced by the secured overnight financing rate data (SOFR) of 1.5%, who will pay that 0.5% risk? These points must be ironed out."
According to Seema Kejriwal Jariwala, partner at BMR Legal, TP and international tax in Mumbai, most alternative reference rates (ARRs), including SOFR, are a mix of secured and unsecured rates, so TP teams will need to take this into account.
Corporations will need to start conversations with tax authorities, according to John Grout, an independent member of the Libor Oversight Committee in London, to ensure that they approve the rate.
The Internal Revenue Service in the US is depending on market participants to use SOFR as a Libor substitute.
The rate could include Libor and an additional variable, such as a credit premium, but the RFR must include the credit risk component.
It is important to take reasonable action, says Grout. "Corporations are using the same premiums that the International Swaps and Derivatives Association is using for swaps. That could be quite persuasive with tax authorities."
Other TP element features might be impacted by the transitioning stage.
According to Grout, if minority shareholders are concerned about any "funny business" going on within the parent company, interest rate changes within the other company groups may have an impact on operational units.
Whatever risk premium and interest rate businesses decide to use in new contracts, they will need to effectively document it, share it with the involved subsidiary, and modify it to the applicable jurisdictions. Any backup plan must be spelled out in detail.
If not, businesses put themselves in danger. A mismatch in pricing for a transaction will result in a legal agreement, which could be bad news for the two parties involved.
For intra-company loans, the TP risk might also be sizable.
"“It’s the parent company itself that is making loans to subsidiaries, that’s where TP is important. If you don’t put proper interest rates on those intra-company loans, you could get in trouble with various tax authorities ," warns Grout.
He adds that authorities might express concern about profit extraction or profit shifting to a region with lower taxes.
It might be thought of as abuse-prone to switch to another rate, even one that is not forward-looking. In this situation, businesses might wait to interfere with transactions until they absolutely must.
Shiv Mahalingham, TP and BEPS regulatory expert at tax advisory firm Cragus Group in Dubai, claims that intra-group agreements, in particular, are not updated as frequently as they ought to be.
"The most efficient way to approach this would be to implement SOFR or other TP benchmark methods in new agreements, so that old agreements become obsolete," he claims.
However, corporations may also be able to refinance the current transaction during the Libor transition.
According to Kerim Keser, managing director of consulting firm Kroll's TP practice in Munich, some businesses will take advantage of the opportunity to analyze, structure, and harmonize their overall intra-company financing arrangements and policy.
"It is important to analyse the legal and factual obligations of the financial transactions impacted and ensure that a transition to a new base rate is performed at arm’s length. Documenting the transition and explaining the arm’s-length nature is key to avoiding misinterpretations by tax authorities," according to Keser.
While progress on the Libor transition has varied from company to company, larger companies have it "on their radar" and are prepared to move away from the rate, according to Sarah Boyce, associate director at the Association of Corporate Treasurers in the UK.
Grout acknowledges that larger clients, who have larger financial stakes, prefer to complete the transition as soon as possible, especially as their treasurers look for clarity.
Smaller ones, however, lack the motivation to implement the change.
"A lot of companies don’t see any reason to swap until they have to. The easier thing to do is to continue using Libor while they can," continues Grout.
The Federal Reserve Board and the New York Fed, who jointly chair the Alternative Reference Rates Committee, published a progress report in March 2021 outlining the progress made toward the departure from Libor.
Beyond June 2023, there are expected to be approximately $74 trillion in unfinished business under US Libor. While the US Libor is still a part of loan agreements, according to Mahalingham, SOFR is gaining "a lot of momentum."
Edouard Nguyen, a partner at the Paris-based financial advisory firm Kleber Advisory, is unconcerned about the lack of transitioning because businesses still have a year to implement the change.
"They probably have mapped most of their exposure, the list of subsidiaries. They are ready to push the button. Large corporations don’t have purely back-to-back funding. There is already a transforming process at the holding level," he claims.
Banks will typically be the ones to pressure companies to use a different benchmark rate.
According to Nguyen, the banks will control the market for external products funding derivatives in particular, so they will be pressuring businesses to adapt.
However, corporations will probably put off the change in intra-group funding until the very last minute. Any business would take a big risk by doing this.
According to Anne Beaumont, litigation partner at New York law firm Friedman Kaplan, there is a perception that the Libor transition is complete. "I think quite the contrary," she continues. "The coming year will be plenty busy."
Companies with US Libor contracts only have one year to prepare their TP documentation and make sure their new pricing is accepted by the tax authorities, even though the UK market has implemented the switch to RFRs. But any business could run the risk of failing if they wait until the last minute.
By fLEXI tEAM