IBOR Transition

Cristina Blindu, Senior Manager and Ismail Candan, Assistant Manager within the Transfer Pricing department of Deloitte Luxembourg (Photo : Deloitte Luxembourg)

Cristina Blindu, Senior Manager and Ismail Candan, Assistant Manager within the Transfer Pricing department of Deloitte Luxembourg (Photo : Deloitte Luxembourg)

Transfer pricing implications of the interbank rates transition

Since its announcement in March 2021, the Financial Conduct Authority (FCA) and ICE Benchmark Administration (IBA), the administrator of LIBOR, will no longer seek to require panel member banks to compel quotes for interbank offered rates (IBOR) after the end of 2021. This affects the publication of Euro, Swiss franc, Japanese yen and Pound Sterling currencies for all tenors and US-dollars for one week and two months. The publication of US dollars for overnights, one, three, six, and 12 months will cease on 30 June 2023. EURIBOR was reformed in 2019 using a hybrid methodology and it will continue to be published after 2021.

New contracts concluded before 31 December 2021 should be revised to either define a reference rate other than LIBOR, or use existing fallback language that includes a clearly defined alternative reference rate after LIBOR’s. Regulators have published alternative reference rates (Risk-Free Rates, RFR) available on the market.

There are two main transfer pricing challenges to be considered:

1.      Structural differences between rates

There are significant differences between RFR and LIBOR rates. The RFRs are overnight indices, nearly risk-free rates based on actual transactions, whilst LIBORs are term rates representing average survey-based interbank rates at which the banks (representing the survey panel) could borrow. LIBOR rates are hence reflecting a perceived credit and liquidity risk inherent to the interbank market, which makes the fixings for RFRs to be lower than traditional interbank rates. In addition, the RFRs do not include term structures and thus avoid the inclusion of any longer-term lending premium. The key criticism towards the market manipulation of IBOR rates is also limited with the new RFRs given that their constructions rely on wider transaction volumes. The transition will also produce practical challenges in applying the adopted new rates as historical data is not always available for the new RFRs whilst data for traditional IBOR rates will soon no longer be available (e.g. backward-looking vs. forward-looking swap approach).

2.      Review of existing contracts

Market participants should review their legal agreements and ensure there are robust fallback clauses included. Fallback provisions refer to the legal provisions included in a contract and determine the new reference rate/spread adjustment rate to be used by parties in the event that the initial rate is not available. A provision simply allowing the switch from IBOR rates to RFRs may not suffice to cover the transfer pricing aspect of a transaction. Due to their essential differences, tax administrations could argue that the lower fixings could mean that a trade, which transitions from LIBOR to a RFR, has a different market value over time than it otherwise would have had. Thus, the transaction needs to be re-assessed, appraised and documented from a transfer pricing perspective.

To conclude, it is of the utmost importance for taxpayers to assess the transfer pricing implications of the IBOR transition with regards to their intra-group transactions before the disruption of the interbank rates in order to smoothen their transition to the new RFRs in their transfer pricing policies.