A momentous transition for the world’s financial markets is scheduled to take place in the next few years. The London Interbank Offered Rate (LIBOR), a reference interest rate for a variety of financial contracts around the world (e.g., loans, derivatives, mortgages) worth trillions of dollars, is not guaranteed to be published after 2021. LIBOR is designed to represent the average composite rate of interest at which certain leading international banks could borrow from one another on an unsecured basis and is quoted for a number of maturities and currencies. It is calculated based upon submissions from a panel of selected banks. However, the volume of actual transactions (as opposed to theoretical judgments of what rate a bank could borrow funds at if it were to do so) has fallen significantly in recent years, calling into question whether LIBOR is genuinely representative of true market conditions. In addition, even assuming a robust interbank lending market, LIBOR quotes are determined through surveys of money-center banks rather than data on actual transactions among them. Finally, in recent years, serious questions have been raised concerning the governance processes underlying LIBOR.
With the looming end of LIBOR, or at least its relevance as a representative rate, financial regulators around the world, such as the UK’s Financial Conduct Authority (FCA) and the Federal Reserve in the U.S., have been involved in rallying financial market participants to prepare for the transition. In the U.S., the Federal Reserve established the Alternative Reference Rates Committee (ARRC) in 2014 in order to consider criteria for new reference interest rates to replace U.S. Dollar (USD)-denominated LIBOR, as well as related implementation issues (e.g., the facilitation of adoption of alternatives and preparation of recommended contract language). The ARRC originally included representatives from 15 large global interest-rate derivatives dealers. Eventually, several market participants and interested organizations were invited to join as non-voting members.
This article discusses transfer pricing and other U.S. tax implications of the move away from LIBOR, as well as steps that taxpayers should take starting now in order to be prepared for the change. Our focus will be on intercompany financial instruments, particularly debt; many of the issues discussed also apply to third-party arrangements.
U.S. LIBOR ALTERNATIVE RATE
In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the alternative that represents the best replacement rate for USD-denominated LIBOR. SOFR is based on overnight transactions in the U.S. dollar Treasury repo market, the largest rates market at a given maturity in the world. It is considered to be robust, compliant with criteria promulgated by various regulatory bodies (e.g., the International Organization of Securities Commissions, or IOSCO), and is based on a deep and liquid transaction-based market. Separate benchmarks are selected for other currencies by the relevant governing authorities. These benchmarks should be reviewed for intercompany agreements denominated in currencies other than U.S. dollars, and are beyond the scope of this article.
SOFR has a number of characteristics that LIBOR and other similar rates based on wholesale term unsecured funding markets do not:
- It is derived from an active and well-defined market with sufficient depth to make it difficult to manipulate or influence;
- It is produced in a transparent, direct manner and is based on observable transactions, rather than being dependent on estimates, like LIBOR, or derived through models; and
- It is derived from a market that was able to weather the global financial crisis and that the ARRC credibly believes will remain active enough to provide reliable metrics in a wide range of market conditions.
In the time since the Federal Reserve Bank of New York began daily publication of SOFR in 2018, significant progress has been made in building liquidity in SOFR-linked markets (which include dollar-based derivatives and loans). For example, over $49 billion of notional SOFR interest-rate swaps have cleared, and SOFR-linked futures activity has risen significantly. SOFR cash issuances have also grown, to more than $79 billion outstanding, covering market participants such as corporates, financial institutions, and government-sponsored agencies. All in all, since May 2018, the total notional value of SOFR-linked markets has reached more than $7 trillion. (Lingering volatility in SOFR will hopefully diminish as liquidity continues to develop.)
However, SOFR is fundamentally different than LIBOR in a number of key elements. SOFR is (currently) an overnight rate, is secured and is designed to reflect a (virtually) risk-free rate. LIBOR has forward-looking term options, is unsecured and is designed to reflect a bank’s cost of funding. All of these characteristics factor into how SOFR will perform under certain circumstances and how it can be used by market participations.
For example, the following figure compares 3-month LIBOR, one the most commonly used LIBOR benchmarks, to the 3-month simple average of SOFR.
3-Month Average SOFR and 3-month LIBOR
SOFR is generally both lower and, depending on the methodology applied to derive a term structure, less volatile as compared with LIBOR. This is to be expected given the lower risk profile of SOFR, since it represents borrowings collateralized by U.S. Treasury securities while LIBOR reflects interbank credit risk. (The averaging of the SOFR overnight rates smooths out the observed current volatility. Comparisons of averages of overnight SOFR to LIBOR quotes, if the latter incorporates expectations of future interest rates, may be impacted by systematic tightening of U.S. monetary policy, which began in 2016; however, the general relationship between the two rates is expected to hold.)
IMPACT ON INTERCOMPANY AGREEMENTS
From a transfer pricing perspective, intercompany loan arrangements will be directly impacted by the LIBOR transition. Fixed-rate loans will not be affected since the transition should not impact the all-in pricing of risk, only the expression of that pricing. The pricing of floating-rate loans, revolving-credit facilities, and cash-pooling arrangements, however, along with associated contractual terms, will in many cases require adjustment.
For purposes of this article, intercompany financing agreements can be grouped into three categories: new intercompany agreements that will expire after the end of LIBOR; existing intercompany agreements that will expire prior to the cessation of LIBOR; and existing intercompany agreements that will expire after the end of LIBOR. The implications of the LIBOR transition differ for each of these categories.
New Intercompany Agreements
New intercompany financing agreements have the greatest flexibility in dealing with the transition away from LIBOR. When designing a new intercompany loan contract with a variable interest rate, companies should aim to replicate practices followed for comparable third-party loan agreements, which generally leads to two options. The first is to structure the agreement with SOFR as the benchmark. Several companies have issued SOFR-linked debt, as alluded to in the previous section. For example, on May 20, 2019, Goldman Sachs issued a $1 billion floating-rate note benchmarked to SOFR. This removes the need to transition from LIBOR over time, as the financing arrangement would be immediately benchmarked to SOFR.
The second option is to structure the agreement with LIBOR as the benchmark, and include “fallback language” in the agreement which governs the interest resets once LIBOR is gone. The ARRC has provided recommended fallback language for new originations of LIBOR benchmarked loans. This fallback language can generally take one of two approaches:
- The “hardwired approach” provides language to be included in the agreement which specifically designates the replacement benchmark and spread adjustment to be applied upon the end of LIBOR, and the procedures for effecting the change.
- The “amendment approach” allows the parties to amend the loan and specify a new benchmark and spread once LIBOR ends, and governs the relevant processes.
Each approach has advantages and disadvantages. The hardwired approach provides certainty at the origination of the agreement, while the amendment approach may afford greater flexibility (but more uncertainty) by deferring the decision of a replacement rate to a future date when the parties presumably have updated market data available.
The choice of the best tactic—hardwired, amendment, or some combination—will depend on the facts and circumstances of each company.
Existing Intercompany Agreements Expiring Prior to the End of LIBOR
The LIBOR transition anticipates that LIBOR will no longer be published (or will no longer be representative) after the end of 2021. Companies may have existing intercompany agreements with maturity dates prior to the anticipated end of LIBOR. Such existing intercompany agreements can continue to be priced against LIBOR during the interim period. However, we may see a higher level of market volatility as the demise of LIBOR approaches and market liquidity drops even further, triggering interest resets that are more removed from broader market movements or underlying credit risk. Consequently, it may make sense to consider addressing the reference rate for these agreements, particularly if their maturity date stretches into 2021.
Existing Intercompany Agreements Expiring After the End of LIBOR
The final category relates to existing intercompany agreements which mature after the anticipated end of LIBOR. These are agreements already in place whose remaining term will include a portion of time during which LIBOR is no longer expected to be published (or representative).
Intercompany agreements in this category will need to be reviewed to determine the impact of LIBOR’s cessation and, if required, remediate any issues. Without appropriate fallback language, if LIBOR ceases to be published there would be no process in place to compute variable payments, which would lead to significant complications.
It may be advisable to amend existing intercompany agreements immediately using one of the two approaches discussed above with respect to fallback language. Alternatively, companies can wait to amend the agreement if/when LIBOR ceases to be published. Either way, certain processes must be followed in order to avoid a “significant modification” of a financial instrument under U.S. tax rules, as laid out in proposed regulations issued by the Treasury Department on October 8, 2019 (Guidance on the Transition from Interbank Offered Rates to Other Reference Rates,” or “the proposed regulations).
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Sherif Assef (firstname.lastname@example.org) is a principal in the Economic and Valuation Services group of the Washington National Tax practice of KPMG LLP, based in New York City; Yosef Lugashi is a senior manager in the Economic and Valuation Services practice of KPMG LLP, also based in New York City; Petia Petrova (email@example.com) is a senior manager in the Economic and Valuation Services practice of KPMG LLP, based in Boston; and Jeff Nagle is a partner at Cadwalader, Wickersham &Taft LLP, based in Charlotte.
The authors thank Jason Schwartz and Gary Silverstein of Cadwalader,Wickersham & Taft LLP,and Kathleen Dale, Jonathan Zelnik, Bob Clair, and Oommen Thomas of KPMG LLP for their contributions.
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