Background
London Interbank Offered Rate (LIBOR)[1] is a global benchmark interest rate widely used to price financial indentures across economies, including but not limited to standard inter-bank products (like interest rate futures/ options/ swaps/ cap/ floor), commercial field products (like variable rate mortgages) and hybrid products (like collateralized mortgage obligations).
On 27 July 2017, Andrew Bailey, the chief executive of the UK’s Financial Conduct Authority (FCA), announced that market participants should not rely on LIBOR being available after 2021 as FCA will not persuade LIBOR panel banks to continue to submit quotes after 2021. Therefore, FCA has given a clear global direction for adoption of Alternative Reference Rates (ARRs).
Even though various aspects such as timing, etc. pertaining to the global structural change remain open, the key transfer pricing (TP) implications triggered by this change have been discussed below.
TP Implications and Allied Next Steps
- Identification and Renegotiations of Contracts Maturing Beyond 2021
Multinationals frequently undertake intra group financial transactions. The issue arises to determine an appropriate interest rate for such transactions that would comply with the arm’s length principle. Considering the associated complications, the issue has been embroiled in litigation over the years. However, India Inc. has witnessed spate of rulings from various judicial bodies wherein LIBOR (being globally accepted benchmark index) has been considered as a base rate for benchmarking of many such transactions to reach to an arm’s length consideration[2]. But this certainty is short-lived with the impending discontinuation of LIBOR.
Accordingly, in the new world order, organisations will need to identify the affected contracts and renegotiate the terms with their counterparties to transition the base rate from LIBOR to an ARR. In this regard, key points to be considered are as follows:
- ARR identified globally and comparability:
Some of the globally emerging ARRs are as follows:
- Secured Overnight Financing Rate: The ARR selected by US to replace USD LIBOR.
- Sterling Overnight Index Average: The ARR selected by UK to replace GBP LIBOR.
- Euro Short Term Rate: The ARR selected by Europe to replace EUR LIBOR.
- Swiss Average Rate Overnight: The ARR selected by Switzerland to replace CHF LIBOR.
- Tokyo Overnight Average Rate: The ARR selected by Japan to replace JPY LIBOR.
One of the main TP implications resulting from this transition would be to determine appropriate spreads to be applied to ARRs as was also the case with LIBOR, however with appropriate adjustments to account for more differences. Here, one would need to appreciate that transition from LIBOR to ARRs would not entail the applicability of a simple conversion rate as the ARRs generally are currency-specific, overnight rates and they are virtually risk-free as against LIBOR that is available in various currencies, maturities and also have an embedded credit risk associated with bank borrowing.
To explain this point further, on an illustrative basis, the valuation methodology adopted till now may not be implementable in the same way as taxpayers would have to identify additional factors of differences and also make appropriate adjustments for the same. Accordingly, detailed evaluation would have to be undertaken to identify the ARR basis the terms and conditions of different contracts to fulfill TP comparability requirements as taxpayers reassess old arrangements or enter into new arrangements. Further, considering ARRs are specific to region, single ARR may not be suitable for global multi-currency arrangements and thereby, add to the complexities.
In addition, there may be timing differences in the availability of ARRs for specific currency in the early stages of this transition thus, requiring taxpayers to incorporate appropriate fallback provisions in the intercompany contracts.
- Provisions in the Post-BEPS Era:
Adoption of the ARRs as was in the case of LIBOR, would have to be mindful of implications due to jurisdictional interest rate limitation provisions pronounced as Section 94B of the Income Tax Act, 1961 (the Act) that has been adopted in the post BEPS era, to limit the deduction that a taxpayer can claim on inter-company financing transactions (both direct and indirect).
- Valuation Impact
LIBORs has become a convenient proxy for general interest rate risk used in valuation and risk modeling and as a discount factor for prepayment schedules and other situations in financial modeling. A wide range of such models will need to be redeveloped using an ARR. Accordingly, present or proposed arrangements that result in international transactions pertaining to tangible and intangibles assets amongst related parties that will impact taxpayers post 2021 need to account for the on-going changes.
- Regulatory Amendments to be Triggered
The Indian TP provisions with reference to LIBOR that would need to be amended are explained below:
- Safe Harbour Rules[3]
Under the safe harbour regime, at present, for the eligible international transaction in the nature of advancing of intra-group loans (referred to in item (iv) of Rule 10TC of the Rules) denominated in foreign currency, reliance has been placed on LIBOR as base rate to determine remuneration.
- Secondary Adjustment[4]
When provisions of secondary adjustment get attracted, the provisions prescribe the use of LIBOR for computation of imputed interest on deemed advances not repatriated to India within the prescribed time limits in case the international transaction is denominated in foreign currency.
Conclusion
From a TP perspective, intercompany financing transactions have always been a contentious issue for both the taxpayers and tax authorities. Accordingly, the underlying renegotiations and other LIBOR transition pertaining to the financial transactions are expected to garner increased attention from tax authorities. Considering this and the fact that 2021 is not too distant, taxpayers need to mobilize efforts now at both the policy and systematic levels (i.e. to design appropriate policies, contractual arrangements, documentation and systems) to ensure effective and efficient management of the transition necessitated by the phasing out of LIBOR.
Also, it is imperative for the Indian Regulators to promulgate the amended provisions pertaining to safe harbor and secondary adjustment in time so that taxpayers can take considered decisions that may have far reaching impact for businesses.
[1] Average reported interest rate at which major global banks can borrow from each other on an unsecured basis. It is quoted in five currencies: British Pound Sterling (GBP), US Dollar (USD), Euro (EUR), Swiss Franc (CHF) and Japanese Yen (JPY) with respect to fifteen maturities ranging from overnight to 12 months.
[2] Some high court rulings in this regard are PCITvs. M/s. Tecnimont Pvt. Ltd.- ITA NO. 487/MUM/2014, PCIT vs. Manugraph India Ltd.- ITA No. 454 OF 2016, CIT Vs M/s. Vaibhav Gems Ltd. (Now known as Vaibhav Global Ltd.) – ITA No. 14 / 2015, CIT vs. M/s Everest Kanto Cyliners Ltd. ITA No. 294 of 2016 and PCIT vs. S B & T International Ltd. – ITA No. 66 OF 2016.
[3] Section 92CB of the Act read with Rule 10TC and Rule 10TD(5) of Income Tax Rules, 1962 (the Rules)
[4] Section 92CE of the Act read with Rule 10CB of the Rules
Contributing Advisors
Myles CulmerDirector, BDO Advisory Services