LIBOR to ARR – TransferPricing (TP) perspective
LIBOR was phased out in December 2021, with final USD based LIBOR ceasing by 30 June 2023, following which financial instruments have to be priced on alternate reference rate (ARR). RBI on 12 May 2023 has asked banks to completely transition away from LIBOR w.e.f. 01 July 2023.
CentralBanks have identified ARR for various currencies such as SOFR for USD, SONIA for GBP, €STR for Euro. While LIBOR is forward looking term unsecured reference rates and includes credit risk, ARR are overnightrates, based on actual transactions in overnight market and is a riskfree rate. Also, LIBOR was available in different currencies and ARR differs with currency. Hence, transition from LIBOR to ARR has various considerations. Further, MNEs would have transitioned to ARR primarily from financial management perspective, based on Group’s financial position, and needs evaluation from a TP angle as well.
Current intercompany agreements for financial transactions have to be reviewed for clauses covering unavailability of reference rates (LIBOR) (fallback provisions), whether alternate reference rate can be mutually agreed or the agreement would be inoperable. Transition can be vide an addendum to the main agreement. It needs to be carefully seen that the transition should not result in it being treated as a new loan arrangement, resulting in other TP implications.
While transition, several factors impact the spread over-and-above the ARR. LIBOR includes credit risk, which has to be quantified and added to ARR. Adjustments, such as specific country risk, made while pricing using LIBOR have to be revisited, since ARR are risk-free rates and is provided by respective central banks.
Difference in approach i.e., LIBOR is forward looking and ARR’s are backward looking is also a key factor during transition and would have to be factored while arriving at the ALP interest based on ARR.
Where intercompany agreements are based on fixed interest rates, one has to revisit the terms, including if payment of interest at a fixed rate is itself at arm’s length. Revision to floating rates based on ARR can also be considered depending on if there are any efficiencies, at the Group level.
Guarantee fees (CG fees) to be revisited, if yield approach is used to arrive at arm’s length CG fees. In the yield approach delta between interest rates of unguaranteed and guaranteed loans (based on LIBOR rates) is the CG fees. Other TP areas referencing LIBOR include Advance Pricing Agreement (APA), Safe Harbour Rules. Transition impact on limitation on interest deduction (94B) to be seen.
Therefore, it’s imperative that a detailed analysis is undertaken to revisit the existing financial transactions from a TP perspective.