One of the world’s most important interest rates—the London Inter-bank Offered Rate (LIBOR)—is being phased out. Despite its official termination being a few years off, many industry experts have expressed concern that the LIBOR discontinuation could pose a significant risk to global financial markets. Why is it phasing out, and how can you prepare? We’ll get to all of that below.
What is LIBOR?
The London Inter-bank Offered Rate is a global interest rate that major banks use as a benchmark for borrowing with one another. In addition to setting rates for interbank loans, LIBOR is often used for setting interest rates for adjustable-rate mortgages and credit cards.
LIBOR is considered a term-based rate, which means it’s broken down by different maturity periods such as overnight, weekly, one-month, three-month, six-month, and 12-month loans. It’s also calculated for five of the leading global currencies: the U.S. dollar, the British pound, the Japanese yen, the Swiss franc, and the euro.
Why is LIBOR going away in 2021?
Despite being a well-established benchmark for global interest rates, LIBOR has faced significant criticism over the years. LIBOR is problematic because it only measures the estimated interest rate that banks use to borrow from one another; however, it does not measure the actual interest rates from real transactions.
Because it is an estimate, LIBOR is hypothetical and can be easily compromised. In fact, in 2012 there was a major scandal alleging that some of the participating banks manipulated the LIBOR rate to their own benefit by providing inaccurate estimates of borrowing costs.
With these issues in mind, a decision was made to stop publishing LIBOR in 2021.
Will LIBOR be replaced by an alternative rate?
The U.S. Federal Reserve Board and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to explore potential LIBOR replacements and to develop an implementation plan for the transition.
They recently identified the Secured Overnight Financing Rate (SOFR) as an alternative rate, which measures the cost of borrowing cash overnight based on repurchase agreements of U.S. Treasury securities. SOFR is considered a secure, risk-free rate because it’s collateralized by the U.S. Treasury. It’s also based on more actual transaction data than LIBOR, making it a more accurate measure of the cost of borrowing short-term loans.
There is some cause for concern because SOFR does not have a term structure like LIBOR, and only reflects the overnight rate. With that said, the ARRC is currently working on a three-month SOFR, which is a term interest rate derived from the average daily SOFR rate.
Need guidance on how to prepare for the LIBOR transition? Talk to one of our expert advisors to learn how we can help.
How does the LIBOR phase-out impact your transfer pricing?
The LIBOR discontinuation has implications for the entire financial market—but how will it impact your company’s transfer pricing strategy specifically?
It all comes down to intercompany financing agreements, which can have either fixed or floating interest rates. Fixed interest rates are a set percentage that do not fluctuate over time, while floating interest rates are spread over a benchmarked rate. In most cases, LIBOR is the rate that’s used in transfer pricing documentation as a benchmark for assessing the arm’s length nature of intercompany loans. Once LIBOR is phased out, transfer pricing documentation and intercompany financing agreements will need to be updated to include a replacement rate.
While there is still a lot of uncertainty at the moment as to how multinational organizations should address the LIBOR transition, companies can take the following steps to prepare: (Tweet this!)
1. Amend existing intercompany financing agreements.
Because a majority of legacy intercompany financing agreements reference LIBOR, it’s imperative that you amend these contracts to specify a replacement rate like SOFR—particularly in the case of contracts that extend beyond the LIBOR phase-out in 2021. Amending your existing credit agreements will avoid potentially defaulting to a more costly alternate base rate (ABR) or prime rate.
2. Develop fallback language for all new LIBOR transactions.
Another way you can prepare for the transition is to include fallback language in new transaction contracts that reference LIBOR as a benchmark. Doing so means you’re proactively managing your risk level while the transition is still ongoing. The ARRC has published recommended contractual fallback language to help promote market consistency throughout the LIBOR transition process.
3. Evaluate how SOFR will impact your intercompany transactions.
Lastly, educate yourself about SOFR and evaluate how the shift will impact your past, present, and future intercompany agreements and their underlying transactions. SOFR is already published daily by the Federal Reserve Bank of New York and can be monitored throughout the transition. The ARRC has also recommended pre-cessation triggers for companies that wish to transition to SOFR in advance of LIBOR’s 2021 discontinuation.
There is still a lot of work to be done before companies are ready to make the documentary and operational changes necessary for transitioning from LIBOR to SOFR. Every organization that has exposure to LIBOR needs to take steps now to prepare for the inevitable discontinuation of the established reference rate in just a few short years.
Let Us Get You Prepared For LIBOR’s Phase-out
Change be daunting—especially when millions, billions, and even trillions of dollars are at stake. With the LIBOR transition looming and tax authorities keeping an increasingly close eye on intercompany agreements and transactions, there has never been a better time to put your company’s transfer pricing activities in expert hands.
Our seasoned consultants at Valentiam have extensive experience assisting with the implementation of intercompany agreements for our clients. We can work with you to ensure your organization is prepared for the transition away from LIBOR—and the increased scrutiny that will come along with it.
Get in touch for expert advice on managing your company’s intercompany agreements, and ensuring all your related-party transactions are carried out at arm’s length.
Topics: Transfer pricing
