According to the Financial Conduct Authority (FCA), UK, LIBOR (London Interbank Offer Rate) will either be discontinued by any administrator or no longer be considered a representative rate.
As a result of the above, the Reserve Bank of India (RBI) issued a letter to all Indian banks to ensure that no new transaction undertaken by them, or their customers rely on or are priced using the LIBOR or the Mumbai Interbank Forward Offer Rate (MIFOR) which is derived from LIBOR.
This article analyzes and discusses recent developments in the transition away from LIBOR from a Transfer Pricing perspective.
Alternate Reference Rate (ARR’s)
While businesses adjust to a world without LIBOR, the potential impact of this fundamental change on their arm’s-length interest rates for intercompany borrowings is need of an hour. As a result, ARRs have gained prominence which are as follows:
Table: Currency-wise ARRs
LIBOR currency Proposed Replacement Transaction Type
USD SOFR – Secure Overnight Funding Rate Secured
GBP SONIA – Sterling Overnight Index Average Unsecured
Euro ESTR – Euro Short Term Rate Unsecured
CHF SARON – Swiss Average Rate Overnight Secured
JPY TONAR – Tokyo Overnight Average Rate Unsecured
The terms ’near risk-free rates’, ‘risk-free rates’, and ARRs are generally accepted as interchangeable and should be defined as LIBOR alternatives developed by international central banks.
LIBOR v. ARRs
The only commonality between LIBOR and ARRs is the risk-free component. The major differences between LIBOR and ARRs are as follows:Table: Key difference between LIBOR & ARRs
Parameter LIBOR ARR
Calculation Methodology Submission from panel banks Based on actual transactions
in liquid markets
Term Structure Term structure with seven
different forward-looking tenors, Backward-looking overnight rates
from overnight to 12 months
Credit Risk Premium Reflects cost of borrowing by panel Are proxies to risk-free rates
banks and thus, includes credit and have no credit premium
Timing of rate publication Based on consistent methodology ARRs have different
across the 5 currencies and published methodologies and publication
at the same time timelines for each currency
Methodology All 5 Currencies follow same methodology Each Currency has different methodology
A primary challenge is identifying and adopting suitable ARRs to replace LIBOR. Various jurisdictions and markets have chosen different rates, which are as follows:
- As the basket of currency becomes wider, banks and financial institutions must assess the suitability of these rates for their specific products and contracts to avoid contractual fallback(s). This can be a complex process, as it involves changes to legal, operational, and documentation provisions.
- Additionally, shifting from LIBOR requires significant adjustments to internal processes, systems, and models.
- The ARRs also pose challenges in terms of market liquidity and product availability, which can lead to market inefficiency and potentially affect the pricing and availability of certain financial products.
Credit Spread Adjustment
A spread adjustment is meant to reduce the difference between LIBOR and SOFR. ISDA (International Swaps and Derivatives Associations) – has prescribed using 5-year historical median difference between LIBOR and SOFR compounded-in-arrears to arrive at the static spread adjustment.
Transfer Pricing Implications
As per the Transfer pricing requirements, the interest on intercompany loans will be required to be benchmarked and justified to be at arm’s length. Such transition will affect the interest rates for existing intercompany loans which are required to be freshly benchmarked and updated.
The transition of LIBOR may have an impact on concluded APAs ((1) Loan and (2) Corporate Guarantee Transactions).
Safe Harbour Rules
The Safe Harbour Rules provide margins with LIBOR as a base which will require an update.
Due to the scope of the LIBOR phase-out’s impact, it is important for group companies having existing intercompany loans and guarantees to manage this transition carefully and to account for any differences between the two rates (i.e., LIBOR and new ARRs). The recommended first step is for companies to identify intercompany agreements containing LIBOR references and modify those agreements.
To the extent LIBOR is referred to in existing agreements, appropriate fallback language should be included – for both Related and Third-party Agreements. Now is the time to create/update robust documentation along with detailed benchmarking and backup should be maintained to explain any position if challenged.