Transfer Pricing of Interest Rates in the post-LIBOR era

The London Interbank Offered Rate or LIBOR has been a fixture in financial markets for almost four decades. Governed by the British Banking Association (“BBA”) from the mid-1980s to 2014 and the Intercontinental Exchange (“ICE”) thereafter, LIBOR is used as a reference rate to price interbank loans and options, commercial products like variable rate mortgages and floating rate certificates of deposit, and intercompany financial transactions and derivatives such as futures, swaps and options.

Approximately USD 300 trillion in derivatives and other financial contracts (such as loans) have interest rates that are referenced to LIBOR. Five global currencies (the US Dollar, the Pound Sterling, the Japanese Yen, the Euro and the Swiss Franc) and seven maturities (overnight, one week, and one, two, three, six, and 12 months) are polled for, resulting in thirty-five different LIBOR currency/maturity pairs being reported for each day¹. LIBOR rates are published every business day in London – except for overnight LIBORs in US Dollars and Euros, which are published for every business day in London excepting US and European public holidays, respectively.

Background

LIBOR has been computed by polling a specific panel of banks about the rate at which they judged that they would be able to borrow in a specific currency in a specific maturity. Starting in 2008, investigations by the press and regulators began uncovering evidence that panel banks had been manipulating LIBOR to advantage their own trading operations, or to show that the bank could borrow at comparatively lower rates for reputational purposes². Regulators in the United States, the United Kingdom and the European Union investigated these manipulations and undertook enforcement actions against several multinational banks and financial institutions leading to levying of fines exceeding USD 9 billion³.

Following these revelations, regulators brought about several changes in the administration of LIBOR, and in 2017, the UK Financial Conduct Authority (“FCA”) announced that it would not mandate banks to provide data for the computation of LIBOR beyond 2021⁴. As a part of this process, on 5 March 2021, the ICE announced that all LIBOR rates in Pounds Sterling, Euros, Swiss Francs and Japanese Yen and US Dollar LIBOR for the 1 week and 2 months maturities would stop being published after 31 December 2021, while US Dollar LIBOR in the overnight, 1 month, 3 months, 6 months and 12 months maturities would stop being published after 30 June 2023⁵.

LIBOR in an Indian Transfer Pricing Context

This issue is important for Indian companies that have entered into inbound or outbound intercompany loan arrangements. From a transfer pricing perspective, the Income-tax Appellate Tribunal (“ITAT”) has held on multiple occasions (starting from the decisions of the Chennai bench of the ITAT in Siva Industries⁶, the Hyderabad bench of the ITAT in Four Soft⁷ and the Mumbai bench of the ITAT in the case of Tech Mahindra⁸) that arm’s length rates for intercompany loans denominated in foreign currencies should be referenced to LIBOR rather than domestic, rupee-denominated rates such as the prime lending rate or the base rate or interest rates charged by banks on rupee-denominated debt.

The ITAT also ruled specifically on contentions that LIBOR should not be used as a reference rate in arm’s length determination in the case of Vijay Electricals⁹ where the Hyderabad bench of the ITAT ruled that:

Additionally, the all-in-cost ceiling for external commercial borrowing (“ECBs”) allowed by the RBI is also referenced to 6-month LIBOR¹⁰ in the relevant currency. Even the Safe Harbour for intra-group loans provided by an Indian taxpayer to its associated enterprises in foreign currency is referenced to 6-month LIBOR in the appropriate currency¹¹.

Due to these factors, a large number of intercompany loans have interest rates that are referenced to LIBOR. This has led to many Indian companies borrowing from related parties doing so on the basis of LIBOR-linked interest rates – as per RBI figures, there were USD 74 billion of outstanding ECBs where the interest rate was linked to LIBOR¹².

In light of the upcoming sunset of LIBOR, regulators in the US, the UK, the EU and indeed all over the world are taking steps to ensure that the transition is handled smoothly. In India, the RBI issued a “Dear CEO” letter to scheduled commercial banks in August 2020 about making sure their clients were prepared for the end of LIBOR.

This is especially important from a transfer pricing perspective since Indian companies that have borrowed from related parties on the basis of a LIBOR-linked interest rate face two risks from the scheduled end of the LIBOR era:

LIBOR’s Successors

Regulators for the jurisdictions where LIBOR is the domestic interbank benchmark have each identified alternative benchmarks for the post-LIBOR era. These include the Secured Overnight Financing Rate (“SOFR”) for the US Dollar and the Sterling Overnight Interbank Average Rate (“SONIA”) for the Pound Sterling. These rates are different in many ways from LIBOR:

Both SOFR and SONIA are calculated based on the interest rates on actual overnight lending. Both are secured rates, and both lack the term structure of LIBOR – unlike LIBOR which existed in seven different maturity categories, there is only one SOFR.

However, there are encouraging signs that these alternative reference rates are beginning to be referenced in a number of financial transactions. In the first quarter of 2020 for example, there were bond issuances of over USD 200 billion referencing SOFR, and bond issuances of over GBP 18 billion referencing SONIA. The use of these rates in futures, swaps and other derivatives is also increasing. From a transfer pricing perspective this is especially important, since as mentioned above, identifying comparables referencing a common reference rate (for a specific currency) would be important for price-setting and testing at year-end¹³.

Some of the challenges caused by the difference between the alternative reference rates and LIBOR (from a transfer pricing perspective) should be ameliorated by the emergence of such deep markets of transactions or contracts that reference alternative rates. For example, although the SOFR is constructed from interest rates on secured loans, a transfer pricing analysis for an intercompany loan that is unsecured could still identify an arm’s length rate that references SOFR, provided that suitable comparable transactions that are also unsecured and that reference SOFR can be identified. Given that US regulators are keen to ensure that the SOFR is adopted in place of LIBOR, it is likely that such comparable transactions would eventually come into existence.

Intercompany Loans Referencing LIBOR – The Way Forward

As discussed in the foregoing sections, Indian taxpayers who have entered into financial transactions where the interest rate references LIBOR and extends beyond the sunset of the relevant LIBOR rate face two risks – that the specific LIBOR rate referenced in their contract simply may not exist at a time when interest payments come due and the rate has to be calculated, and that comparables referencing LIBOR do not exist for a period where that transaction under review is still referenced to LIBOR.

Hence, Indian taxpayers with intercompany financial transactions such as ECBs, where the interest rate references LIBOR and the life of the transactions extends beyond the sunset date of the relevant LIBOR rate need to plan for the period beyond LIBOR.

Step 1: Scoping Exposure in Existing Intercompany Contracts & Policies

A first step to planning for the post-LIBOR reality would be to analyse existing intercompany loan agreements, transfer pricing policies and other documentation to determine where the exposure to LIBOR exists. Further, as discussed above, a substantial body of Indian transfer pricing case law exists that reinforces the use of LIBOR as a reference rate in the arm’s length price determination of intercompany financial transactions that are undertaken in foreign currencies. Hence, transfer pricing planning reports, transfer pricing documentation studies and transfer pricing master files should also be analysed to ascertain where the Indian taxpayer and the international group of which it may be a constituent entity relies on LIBOR either to set prices for financial transactions or to determine arm’s length prices.

Step 2: Addressing the Spread & Structural Mismatch

Once the exposure of the Indian taxpayer and the group to LIBOR has been determined, however, fixing this exposure and ensuring that the company and the group are ready for the post-LIBOR world is not as simple as simply replacing LIBOR in intercompany agreements, transfer pricing policies, documentation studies and master files with the relevant successor rate such as SOFR and SONIA.

As mentioned in the foregoing sections, these successor benchmark rates differ in many respects from LIBOR – for example due to their being secured rates as opposed to LIBOR, which is based on interest rates for unsecured borrowing. This would imply that the equivalent of, for example an interest rate expressed as 6-month USD LIBOR plus 200 basis points would not be SOFR plus 200 basis points due to SOFR’s lack of a term structure and due to it measuring a fundamentally different set of transactions than LIBOR did.

Conclusion

LIBOR, the lynchpin of the international financial system for over three decades is coming close to its end, and Indian taxpayers with intercompany financial dealings with rates referencing this rate will have to join myriad other financial market participants in planning for the end of the benchmark.

We have discussed two approaches to manage this transition for Indian taxpayers with intercompany contracts referencing LIBOR beyond the sunset dates of LIBOR – either relying on transitional mechanisms developed by global regulators such as the State of New York or the FCA, or to conduct fresh transfer pricing analyses to determine new comparable transactions whose rates reference benchmarks such as SOFR or SONIA.

Whichever approach is selected, it is imperative that taxpayers act to identify their exposure to LIBOR in their intercompany dealings and put in place mechanisms to move past the end of LIBOR. While LIBOR for certain currency and maturity pairs is slated to end in less than a year, prompt action could ensure a smooth transition and operational transfer pricing and transfer pricing compliance issues for the parties involved.