With the sunsetting of the London Inter-bank Offered Rate (Libor) on the horizon, multinational companies should assess potential exposure points and develop a transition strategy to identify and replace references and dependencies, including with respect to intercompany positions. In almost all cases, barring certain safe harbors, the arm’s-length standard must be applied when setting prices for intercompany loans, and the switch away from Libor (whether terminating or updating existing arrangements) is no exception. This switch should seek to mirror market behavior; otherwise, companies will potentially face tax risk and exposure. The transition away from Libor may also present opportunities to identify and implement relatively more tax-efficient solutions, so long as they do not deviate from the arm’s-length standard.
Status of Libor
In the U.S., the Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Federal Reserve, was established to help ensure a successful transition from U.S. dollar (USD) Libor to a more robust reference rate. ARRC has released a “Practical Implementation Checklist” (Checklist) that contains a series of USD Libor transition considerations across a set of work streams to aid in the transition. This Checklist provides a starting point for a successful transition.
Also, to aid in the successful transition of USD Libor, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (collectively, the “U.S. Agencies”) provided a “Statement on Libor Transition” at the end of 2020, which provided additional detail “in order to facilitate an orderly—and safe and sound—Libor transition.” Specifically, in their Nov. 30, 2020 release, the U.S. Agencies:
- Encourage banks to cease entering new USD Libor contracts as soon as practicable and in any event by Dec. 31, 2021.
- Note that publication of USD Libor (except one-week and two-month USD Libor) will extend until June 30, 2023, allowing contracts entered before Dec. 31, 2021, and maturing before June 30, 2023, to mature without any transition required.
- State that new contracts entered on or after Jan. 1, 2022, should use a base rate other than USD Libor or include robust fallback language that defines how the base rate should be calculated following USD Libor’s discontinuation. Proposed fallback language is available in ARRC’s June 30, 2020, recommendations, available here.
While still early days post-release, we understand that most banks are moving forward with their transition plans with only minimal delays, if any. We also understand that some banks are considering whether to transition all agreements as of the end of 2021 irrespective of whether Libor continues to be published through mid-2023 due to hedging issues and basis exposures. As such, while the release from the U.S. Agencies should make for a smoother transition, it may not materially alter transition plans, especially those of large banks. The behavior of these banks is also consistent with the U.S. Agencies’ continued encouragement of transition away from USD Libor as soon as practicable. For smaller financial institutions and non-financial institutions, the details of the release may provide reprieve and additional time to facilitate a successful transition away from Libor, as discussed below.
The transition away from Libor is truly a global issue. Libor is used in financial products denominated in several currencies and is published in GBP (British Pound), USD (U.S. Dollar), EUR (Euro), JPY (Japanese Yen), SGD (Singapore Dollar), HKD (Hong Kong Dollar), AUD (Australian Dollar) and CHF (Swiss Franc) among others. As such, transition committees have been set up internationally to introduce their own local-currency-denominated alternative reference rates for short-term lending and to continue to develop strategies for the transition. While the U.S. Agencies Release is specific to USD Libor, similar changes are expected to follow for other non-USD-denominated Libor, although transition seems to be at different stages of progress.
Considerations for Transition Strategies
As firms initiate or progress with Libor transition plans, they should not lose sight of their intercompany arrangements. Like market arrangements, intercompany arrangements need to be transitioned, which should occur in an arm’s-length manner. Below we explore four primary considerations for developing and implementing a successful intercompany Libor transition strategy.
Collate Relevant Intercompany Agreements to Identify Potential Exposure Points
An imperative initial step is to develop a flexible approach to identify and monitor Libor-linked product exposure through the transition period and understand where transition issues may exist. As with market positions, companies must identify all potential intercompany exposure points. Per the U.S. Agencies’ Release, a USD Libor exposure point would be defined as any existing contract or new contract entered prior to Dec. 31, 2021, that relies on a USD Libor base rate and does not mature before June 30, 2023. This revision may eliminate some previously identified exposure points. There may however be a rationale for transitioning all agreements before Dec. 31, 2021, to keep rates consistent. In that case, the scope of relevant contracts is broader.
Identifying exposure points requires obtaining and reviewing existing arrangements, including any underlying agreements. This may not be a trivial task, depending on your company’s financing structure. It has been our experience that many enterprises do not store all contracts in a central location and are not aware of who within the organization is responsible for each. To the extent your agreements are voluminous, not standardized, and/or decentralized, technology can be leveraged to locate and harvest relevant data such as effective dates, rate dependencies, fallback language, amendment capabilities, and termination.
Impact Assessment and Analyses
The next step is to estimate the magnitude and impact of your Libor exposures. This may include consideration of factors such as Libor provisions, the coupons on the Libor instruments, market adoption, product and currency liquidity, current and stress market conditions, regulatory consequences, performance impacts, etc., to the extent they are relevant.
Your intercompany agreements may vary in the level of detail or may lack provisions on the Libor transition altogether, as intercompany agreements tend to be streamlined and lack details beyond basic terms. A precursor to forming a successful Libor transition plan is to understand what is required and/or permitted under the terms of all agreements that reference Libor or where guidance is lacking.
Determine a Transition Strategy
Once you understand what is legally possible, you can develop a transition strategy. In certain situations, the best path may be to follow the letter of the agreement as legally written. In other situations, including where such guidance does not exist, you might consider your company’s behavior in market-based arrangements or market behavior more broadly. Finally, it may make sense to consider commercially reasonable strategic alternatives such as restructuring or refinancing. It is not necessary and may not be advantageous to apply a one-size-fits-all approach to Libor exposures. There is the opportunity to prioritize your largest exposures, for which a detailed, and perhaps, strategic analysis is warranted. For relatively smaller exposures a more standardized approach may provide the most effective and efficient transition. The options below can be applied to different loans or groups of loans based on your priorities.
Option 1: Redefine Terms of an Existing Intercompany Arrangement
Depending on the terms of the arrangement, this will likely involve selecting a new reference rate and recalibrating the spread to obtain parity. This may not be as simple as swapping Libor for a new base rate (e.g., the Secured Overnight Financing Rate [SOFR]) and may require some level of documented economic analysis to support the alternative reference rate’s equivalence, as well as amendment or repapering of the arrangement. The same steps could be taken if a switch is made from a floating rate Libor-based loan to a fixed-rate equivalent.
Option 2: Set Terms of a New Intercompany Agreement
Contemporaneous benchmarking and documentation of an arm’s-length interest rate based on the proposed terms of the new intercompany agreement and current creditworthiness of the borrower should be undertaken for new loans, which could be priced based on a fixed or floating rate. It is also important to ensure your prior agreement is terminated, consistent with any legal provisions and arm’s-length behavior of both lenders and borrowers.
Implement, Document,and Test Your Strategy
In addition to the legal aspects (e.g., amending, repapering, terminating, drafting, etc.), implementation may also necessitate updating systems and models that pull real-time data for the applicable alternative rates to calculate the intercompany impact. There may be other indirect implementation impacts, so it is important to implement and test your approach well before the decommissioning of Libor. Finally, don’t overlook documentation, especially in light of the increased attention on intercompany financial transactions evidenced by the recent release of transfer pricing specific guidance on financial transactions by the OECD.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Stefanie Perrella is a managing director in the Duff & Phelps New York transfer pricing practice. Jennifer Press is a managing director in the New York office and part of the alternative asset advisory practice. David Ptashne is a director in the transfer pricing practice in Chicago.
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