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The Transition From LIBOR to SOFR and its Implications for Taxpayers

Oct. 20, 2021, 7:01 AM

The transfer pricing landscape has continued to witness significant change, with the most recent development in conducting interest rate benchmarking gaining momentum. In July 2017, the regulator of the London Interbank Offered Rate (LIBOR)—the U.K. Financial Conduct Authority (U.K. FCA)—announced that LIBOR would be phased out in late 2021. (It is however important to note that the termination of some US dollar LIBOR tenors has since been postponed to 2023.)

This announcement will see governments and companies alike embracing new replacement rates for determining the applicable interest rates for financing arrangements. Even though some countries, like Nigeria, are yet to choose an alternative rate, both regulators and taxpayers need to take swift action to understand how such fundamental changes will impact their operations and daily functions.

The preferred alternative rate for the U.S. would be the Secured Overnight Financing Rate (SOFR), having the Federal Reserve as the administrator. Other jurisdictions appear to be taking a different approach. For instance, the U.K. opted for the reformed Sterling Overnight Index Average (SONIA) with the Bank of England as the administrator. Japan, on the other hand, chose the Tokyo Overnight Average Rate (TONAR) to replace yen LIBOR, while Switzerland chose the Swiss Average Rate Overnight (SARON) to replace Swiss franc LIBOR.

While we cannot say this with complete certainty, it is safe to assume that some jurisdictions in Africa may opt for SOFR, as this has been the trend that we have observed for most companies that have recently been conducting interest rates benchmarking studies to determine arm’s-length interest rates for intercompany financing arrangements.

In this article, we seek to examine the proposed alternatives to the interest rate benchmarking (with a specific focus on SOFR) and assess the potential impact on taxpayers of the transition from LIBOR .

Phase-Out of LIBOR

The uncertainty surrounding the use of LIBOR began long before the U.K. FCA made its announcement in 2017. In 2011, it came to light that certain banks had manipulated the LIBOR benchmark rate by decreasing the interbank borrowing rate, increasing the creditworthiness of banks, and consequently changing the rate for the individual traders to gain profits. Ultimately, this raised concerns over the future of LIBOR which primarily contributed to the reasons that led to the U.K. FCA’s deciding to phase it out.

SOFR Versus LIBOR

LIBOR has been defined as a benchmark interest rate index used to adjust variable-rate loans. It is used by global banks when charging each other for short-term loans and its daily publication dates to 1986. LIBOR is published for each of the five major currencies, which are the U.S. dollar, the Swiss franc, the euro, the pound sterling, and the Japanese yen.

And while other alternative rates will take effect soon, LIBOR rates, as of today, are still at the core of the financial system, providing a reference for the pricing of a wide array of financial contracts, including derivatives, loans, and securities.

Conversely, SOFR is considered to be a market-driven, secured borrowing rate based on an established lending market with money market mutual funds, asset managers, securities lenders, and securities dealers, among others, being the principal participants in the overnight repurchase market.

The key difference between LIBOR and SOFR is that LIBOR is an unsecured rate and represents banks’ estimates as to their cost of funds, while SOFR is a secured, risk-free rate.

Another notable difference is that there is a significantly higher volume of SOFR-based trading and in the underlying nature of the rate itself. As such, the higher volumes make SOFR safer from manipulation than LIBOR.

Additionally, SOFR currently exists only as an overnight rate, whereas LIBOR has seven different forward-looking tenors (overnight, one week, one month, two months, three months, six months, and 12 months). To put this into context, a practical example in which SOFR can be used in place of LIBOR is when, for instance, replacing three-month LIBOR with a rate based on SOFR.

One of the setbacks foreseen with the use of SOFR is that not enough data history exists, which might lead to reliability issues for risk management and volatility models that rely on historical data, ultimately leading to increased complexity in valuing transactions. Refinancing challenges may also arise, since SOFR is an overnight rate and may not be sufficiently liquid.

However, it is conclusively assumed that SOFR is less susceptible to market manipulation and therefore preferred to LIBOR.

Implications of Transition

We have examined the implications of the transition from LIBOR to SOFR from two angles: from a regulator’s perspective and a taxpayer’s perspective. In examining the implications, we have also highlighted the responsibilities of regulators and taxpayers during this transition.

Central Banks and Tax Administrators

Accomplishing a smooth transition from LIBOR to SOFR by taxpayers begins with regulators, in particular, central banks and tax authorities, making a formal announcement and issuing guidelines to address the tax treatment of alterations made to the instruments to replace LIBOR with alternative rates.

Perhaps most importantly, regulators also need to better prepare taxpayers for the degree of change that is about to take effect in the phase-out of LIBOR.

Therefore, to facilitate the transition away from LIBOR, regulators should proactively provide guidance, initiate conversations, and educate taxpayers around the transition to alternative rates to ensure that no information gap exists between the two parties.

A transition plan cannot be successfully executed without robust communication and appropriate governance and oversight, and could introduce considerable costs and risks for taxpayers if not managed properly.

Therefore, an effective communication plan should facilitate the identification, development, and execution of key communication, guidelines and training activities for taxpayers while raising awareness. The window for regulators to act is closing fast, and failure to provide guidelines and direction will eventually prove disruptive.

Taxpayers

The phasing out of LIBOR will undoubtedly have a significant impact on companies’ operations. It is also worth noting that the degree of change is so significant that companies need to take a fresh look at the entirety of their operating model and strategy as it relates to financing arrangements.

The changes and issues that companies/taxpayers should consider include the following.

Revision of Contracts

Because SOFR is a secured risk-free rate based on overnight transactions and does not incorporate a risk premium, it is expected that the transition from LIBOR to SOFR will result in different credit spreads over the selected reference rate. Companies will therefore be required to conduct a comprehensive review of all documentation of financial instruments where LIBOR is directly and indirectly referenced.

Consequently, contracts that are valid beyond the end of 2021 will need to be amended to deal with the phase-out of LIBOR.

Accordingly, accounting implications may result in the de-recognition of contracts or discontinuation of hedge relationships. By identifying their LIBOR exposure and outstanding hedge relationships, financial institutions can assess whether an amendment to their contracts is needed and evaluate how their existing hedges might be affected.

The wording of the contracts may also be revised such that it incorporates the new rate alternative as well as spread adjustments to minimize the difference between LIBOR and SOFR.

Risk Assessment

There is a need for companies to understand and mitigate risks and ensure the lowest impact on a fund’s net asset value. Companies may need to perform a post-transaction valuation and update their records to reflect the implications of the new rates across different business units, such as risk management, legal, portfolio management, accounting, finance, treasury, etc.

For example, updates to records are needed for multiple valuation and risk systems, such as credit adjustments and term structure updates, which may be a result of the alternative rates.

There is also the need to evaluate key risks arising from each of the transition scenarios and the respective transition strategy, and prioritize based on the risk assessment for each transition scenario. For example, a transition that will most likely change a bank’s market risk profiles will require changes to risk models, valuation tools and hedging strategies.

Tax Implications

The proposed alternative rates are calculated differently and payments under contracts referencing the new rates will likely differ from those referencing LIBOR. Therefore, companies may decide internally to add a fallback provision to handle the eventual future transition to an alternative rate (e.g., a provision stating the alternative rate that will apply to the instrument once the current LIBOR rate becomes unavailable).

Another practical example is where alternative rates may result in the parties to the instrument realizing gain or loss. This raises several tax questions, such as whether the alterations are treated as a taxable event. It is therefore paramount that taxpayers seek clarification from their tax authorities on how to handle such transactions from a tax perspective.

Impact on Financial Statements

Granted, the changes in the fair value measurement will impact the company’s balance sheet. The International Accounting Standards Board has proposed amendments to International Financial Reporting Standards (IFRS) to assist companies in providing useful information to investors about the effects of interest rate benchmark reform on financial statements.

The main proposed amendments relate to:

  • Modifications—a company would not de-recognize or adjust the carrying amount of financial instruments for modifications required by interest rate benchmark reform, but would instead update the effective interest rate to reflect the change in the interest rate benchmark;
  • Hedge accounting—a company would not discontinue its hedge accounting solely because of replacing the interest rate benchmark, if the hedge meets other hedge accounting criteria; and
  • Disclosures—a company would disclose information about new risks arising from the interest rate benchmark reform and how it manages the transition to alternative benchmark rates.

Advanced Pricing Agreements

Advance Pricing Agreements (APAs) could also be an avenue for taxpayers who may be significantly affected by the transition to enter into APAs with other jurisdictions to avoid future transfer pricing disputes. Taxpayers should discuss with their revenue authorities how arm’s-length interest will be calculated going forward on their loan products so that there is clarity on both sides.

Other Considerations

OECD Guidelines on Financial Transactions

Chapter 10 of the Organization for Economic Cooperation and Development (OECD) guidelines on financial transactions encourages the use of a comparable uncontrolled price method (CUP method) for benchmarking loans. It further notes that the availability of market lending data makes the CUP method easier to apply to financial transactions than to other transactions.

The OECD guidance also discourages the use of credit default swaps to benchmark loan credit spreads and reiterates the unreliability of bank opinions as loan pricing indicators.

Based on the foregoing, taxpayers will be mandated to mainly rely on data obtained from loan benchmarking tools in identifying comparable interest rates for the issue or receipt of loans. This requires keen attention when it comes to the drafting of loan contracts and conducting benchmarking studies.

Conclusion

While we await guidance on the alternative rates from the regulators, taxpayers must take a proactive approach in ensuring that there are no unnecessary obstacles on the road to the transition from LIBOR.

It is imperative that taxpayers do more to ensure that they are up to speed with the new requirements, and realizing the magnitude of the impact would allow companies to plan for remediation and transition before the end of 2021.

This means that taxpayers must understand the existing changes, as well as the impact of the changes, on their daily operations. By being ready, companies can respond quickly and confidently to audit requests and generally reduce the risks of assessments.

Similarly, the tax authorities, in conjunction with the central banks, have a vital role to play in educating taxpayers and enabling a smooth transition to the alternative rates.

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

The views expressed herein are personal.

Aimée Dushime is an international tax and transfer pricing specialist.

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