The London Interbank Offered Rate (LIBOR), the most commonly used benchmark interest rate, will cease to exist by the end of 2021. It is anticipated that this will have ramifications for the commercial loan markets, as well as for intra-group financing arrangements.
This alert considers the transfer pricing implications of this development and actions that multinationals need to take in light of LIBOR ceasing to exist.
What will replace LIBOR?
In 2017, the UK Financial Conduct Authority (FCA) indicated that compulsory submissions for LIBOR would cease in December 2021. This is due to concerns that benchmark interest rates (such as LIBOR) remain vulnerable to possible market manipulation. In this respect, significant work is currently being undertaken to establish a set of proposed alternative rates. Central Banks and other supervisory and regulatory bodies are now developing alternative risk-free rates (RFRs) for use instead of LIBOR. The proposed alternative RFRs include the following:
The proposed rates are not new (with the exception of SOFR), and are being used as overnight rates in the wholesale deposit and repository markets. These rates are considered to be more stable than LIBOR, as there are a larger number of underlying market transactions. The major drawbacks of the proposed rates are:How do these rates differ from LIBOR?
- the rates are backward looking;
- the rates do not have different tenors (e.g., 1 week, 1, 2, 3, 6 or 12 months); and
- unlike LIBOR, they will be set at different times (i.e., close of business in the jurisdiction of the relevant currency, not at 11 a.m. London time as presently for all currencies).
What are the implications for intra-group financing arrangements?
As well as the widely anticipated impact on the commercial loan markets, the demise of LIBOR will significantly impact intra-group financing arrangements. The intra-group transactions that may be affected include loans and cash pooling arrangements, where LIBOR is used as the base rate for setting interest rates. When LIBOR is discontinued, intra-group legal agreements that govern such financing arrangements may need to be amended. As a result, transfer pricing studies that support these arrangements may also need to be revised.
Hedging strategies used by treasury centres will also need to be reassessed, as the discontinuation of LIBOR may create mismatches between the loan product and the related hedge and the transfer pricing implications will need to be taken into account.
As a result of this development, market participants have started amending their legal agreements to include the Loan Market Association's (LMA) stopgap enabling wording, which provides a mechanism to make it easier to move to RFRs once those RFRs are known. As Toby Barker, Finance, Projects and Restructuring Partner at DLA Piper UK recommends:
"when amending and restating current loan agreements, ensure that the LMA stopgap wording is included. However, do consider the implications of that amendment at the relevant time and do be aware that this wording does not set out what the replacement rates will be - it just provides a helpful route for migrating to them".
Amending agreements in this way and assessing the implications will make it easier to move to the alternative rate once those rates are known.
From a transfer pricing perspective, multinationals should:
- Conduct due diligence on their legacy transactions and plan for the LIBOR transition;
- Decrease/eliminate reliance on LIBOR for future transactions;
- Include the LMA's stopgap enabling wording in the new legal agreements; and
- Ensure treasury and tax functions are aligned on the new approach that will replace LIBOR.