Addressing the Challenges of the IBOR Transition Under the Arm’s-Length Principle

Declining activity in the underlying unsecured bank funding market, coupled with the attempted manipulation from interbank lending rate panel banks, have led global regulators to plan a transition roadmap from interbank offered rates (IBORs) to alternative reference rates (ARRs).

Although the replacement of existing IBORs is one of the most complex issues from a regulatory and financial perspective, multinational enterprises (MNEs) should not underestimate the potential transfer pricing impact of the transition, in order to take effective steps in evaluating the scale of their exposure and formulate an appropriate individual transition plan.

Background

IBORs are benchmark interest rates (available in particular currencies and for certain tenors) for the unsecured short-term borrowing in the interbank market. These rates are of paramount importance in financial markets and act as reference rates for trillions of dollars in loans, bonds, derivatives, securitizations and deposits. The dependence on IBORs is also coupled with the significant number of inter-company transactions that have been set and regulated for decades based on these benchmarks.

Against this background, starting from 2014 regulators and interested parties intensified their efforts for strengthening the IBOR system and, where suitable, for the transition from IBORs to ARRs, such as near risk-free rates (RFRs). This process was initiated in response both to cases of attempted manipulation in relation to key IBORs, and to the significant decline in activity in the unsecured bank funding market that IBORs are supposed to represent.

The transition is expected to be completed by the end of 2021, as the IBOR system will not be guaranteed to market participants after that date.

Key Features of the Alternative Architecture

New RFRs will be structurally different, since they are typically overnight rates based on actual transactions. Therefore, if with the IBOR system the unsecured interbank lending rates are published daily for seven different tenors, new RFRs will be provided solely on an overnight basis, necessarily leading to pricing products with a backward-looking approach.

In addition, while IBOR fixing provides market participants with certainty in pricing different tenors at the beginning of the period, the lack of a term rate structure and a yield curve under RFRs will require market participants to take on market risk, since actual pricing will be solely available ex-post, by compounding RFRs overnight rates.

Further, RFRs do not include or imply any theoretical credit or term premium as considered under the IBOR system. The lack of underlying credit transactions for RFRs implies the absence of a dynamic credit component that will likely result in lower reference rates in comparison to the previous IBOR system.

The following chart compares the new RFR—Euro Short-Term Rate (€STR) and the Euro Overnight Index Average (EONIA). (On March 14, 2019, the working group on RFRs recommended computing EONIA by applying a fixed spread to the €STR instead of continuing to rely on panel banks’ contributions. This spread has been determined by the European Central Bank at 0.085% on the basis of daily EONIA and pre-€STR data from April 17, 2018 to April 16, 2019.)

Similar results could be derived comparing the Euro Interbank Offer Rate (EURIBOR) to €STR and the London Interbank Offered Rate (LIBOR) to the Sterling Overnight Index Average (SONIA) or the Secured Overnight Financing Rate (SOFR).

Implications of IBOR Transition Under the Arm’s-Length Principle

The transfer pricing challenges of the IBOR transition do not relate to pricing only but derive also from the application of a proper analysis that encompasses the delineation of the economic and financial relations, the recognition of the accurately delineated transactions, and the selection and application of the most appropriate (transfer) pricing method.

In this regard, an initial major technical challenge relates to the need to (re)examine inter-company agreements in order to establish whether the IBOR transition changes the economic and financial relations between the parties and so the accurately delineated transaction.

For instance, there might be cases where relatively simple amendments (e.g., fallback provisions) may address all the operational issues, but also cases where the transition may require taxpayers to re-evaluate the inter-company arrangements in their entirety.

This means that, in the case of a pure lending transaction, a new examination of the debt capacity of the borrower and a review of the conditions set out in the agreement should be considered, in order to ensure that terms and conditions are in line with the arm’s-length principle.

Considering the compound effect of IBOR transition and the ongoing influence of the Covid-19 pandemic on business results, it is clear that debt characterization may be challenged by tax authorities leveraging the recent Organization for Economic Cooperation and Development transfer pricing guidance on financial transactions.

In the context of a tax audit, taxpayers will probably be required to provide documentation that explains the amendments made to intercompany financing arrangements in order to address the IBOR transition.

As proposed in the discussion paper “Tax implications of Inter-bank Offered Rate reform” released on Aug. 12, 2021 by the Australian Taxation Office, these amendments should in principle be considered consistent with the arm’s-length principle if they are in line with market practice and the most recent recommendations published by the relevant industry and regulatory body, consistent with the transitioning made by the taxpayer of relevant third-party financing arrangements, and limited to the contractual terms necessary to implement the IBOR transition.

Another significant transfer pricing implication resulting from the IBOR transition relates to how to factor into a proper transfer pricing analysis the technical differences existing when comparing the IBORs with RFRs. In this regard, internal pricing methodologies and transfer pricing policies should be reviewed, in order to prevent any form of base erosion and profit shifting.

In terms of pricing, the structural differences should be carefully assessed, also taking into account that RFRs are generally currency-specific and with a very different risk profile. These features will have a major impact on the comparability analysis and on the application of the most appropriate transfer pricing method.

In addition, operational challenges may also arise in accessing comparable data that under current economic circumstances may not be available, and this therefore may negatively affect transfer pricing outcomes.

Conclusion

The IBOR transition is likely not to be a simple rate replacement, but rather a structural reform of reference rates from a business, financial, accounting and tax perspective. In light of the above potential transfer pricing challenges, MNEs should take effective responsibility in evaluating the scale of their exposure to the IBOR transition and formulate an appropriate individual transition plan.

In addition, it is important to note that the disruptive nature of the IBOR transition could support a comprehensive review of the pricing methodologies and approaches taken not only by MNEs but also by local tax administrations. In fact, the transition will necessarily require tax authorities to factor into their transfer pricing analysis the structural differences between IBORs and RFRs, such as the value of credit risk spread, that in the past have never been subject to discussion, in view of the standard practice of considering reference rates as an expression of an arm’s-length price.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Marco Striato is an International Tax and Transfer Pricing Senior Associate at GPBL—Gatti Pavesi Bianchi Ludovici.

The author may be contacted at: marco.striato@gpblex.it