Transfer pricing considerations for LIBOR transition
In less than six months, at the end of 2021, it is probable that the London Interbank Overnight Rate, or LIBOR—a reference point used globally for variable interest rates charged on financial instruments—will be retired and replaced with an alternative system (with the exception of certain legacy contracts utilizing USD LIBOR). Several other government-sanctioned benchmarks for a Risk-Free Rate, or RFR, will be used for all types of variable interest rate contractual arrangements and financial instruments. The phase-out of LIBOR has been heralded since 2012 when the combined forces of a high-profile scandal and the 2009 recession exposed the vulnerabilities and weaknesses of LIBOR and the need to find an alternative. Given the scope of the impact of the LIBOR phase-out, affected businesses should be taking steps now to plan for the transition.
Transfer pricing considerations
As businesses adjust to a world without LIBOR, they should not lose sight of the potential impact this monumental change could have on the arm’s length nature of their transfer pricing with affiliated entities. The scope of this concern will likely be significant given the ubiquitous nature of variable rate loans and other financial contracts between related entities, whether directly between a parent and subsidiary, through a centralized cash management structure such as an in-house bank or via back-to-back lending arrangements.
Replacing LIBOR on these intercompany contracts will require companies to evaluate the current LIBOR-based variable interest rate pricing against an alternative base rate applying an arm’s length spread so that neither party to the transaction is disadvantaged. There are no instructions for how to calculate this arm’s length spread, but such an analysis will need to follow the principles set forth under existing transfer pricing rules.
Companies will also need to ensure that the changes are supported by contractual clauses in their new and existing agreements. To the extent LIBOR is referenced in such agreements, the appropriate fallback language (recommended by the U.S. Federal Reserve’s Alternative Reference Rates Committee or ARRC) should be included, particularly in the U.S. where there are specific rules concerning modifications to debt agreements, as further discussed below.
Rules concerning significant modifications
The U.S. has enacted tax rules under Internal Revenue Code Treasury Reg. §1.1001 that consider an exchange of property (a contract) for another as a taxable event, measured by the difference in the fair market values of the properties. Such an exchange could trigger taxable gains or losses, withholding tax charges or debt being recharacterised as equity.
Recognizing that it is not good economic or tax policy to trigger a tax on an event that is beyond the control of parties to a contract, in 2019, the ARRC implored the U.S. Treasury to consider how LIBOR-influenced contract changes might have unintended federal income tax consequences under Treas. Reg. §1.1001 and that further guidance from the Treasury was needed. The IRS responded to this request and, in October 2020, issued a revenue procedure (Rev. Proc. 2020-44) that addresses the U.S. tax implications of the transition from LIBOR and other interbank offered rates. The revenue procedure provides interim guidance while the IRS works to finalize the proposed regulations issued in October 2019. In summary, the revenue procedure provides that modifications to the terms of debt, derivatives and other financial contracts to replace reference rates based on interbank offered rates with alternative reference rates will not give rise to a taxable exchange under Treas. Reg. §1.1001 or have other adverse tax consequences. Based on this revenue procedure, the risk of a modification triggering a taxable event under Treas. Reg. §1.1001-3 is significantly mitigated if a contract contains the appropriate fallback language and applies arm’s length pricing principles discussed above. There are some hurdles to clear (e.g., the rate must be “qualified rate” and the currencies of the replaced LIBOR and the new rate must be matched and be U.S. dollar-denominated instruments, etc.) but, generally, if the modifications are made as prescribed in the proposed regulations, the risk of triggering a recognizable gain or loss would be eliminated.
Unfortunately, the IRS has not released any guidance under the transfer pricing rules (i.e., Internal Revenue Code Section 482) that would provide similar protection from a transfer pricing adjustment arising from the LIBOR replacement and spread adjustment.
The key to success
The recommended first step is for affected companies to identify intercompany agreements containing LIBOR references and undertake the processes to modify those agreements. Thinking about potentially damaging legal implications now should eliminate them later. Once the impacted agreements are identified, companies should develop a plan to adjust the pricing of their affected arrangements to be ready once LIBOR is discontinued. With less than a year remaining before LIBOR is replaced, being proactive now will help to mitigate or prevent any future business disruptions.