Cyprus: IBOR Transition - Transfer Pricing Implications And Considerations

By the end of 2021, it is expected that the transition of multiple Interbank Lending Rates ('IBORs'), including the London Interbank Offer Rate ('LIBOR'), will take place. These IBORs are expected to be replaced, to an extent, by Alternative Reference Rates ('ARRs'). There are multiple implications in the financial systems that may arise as a result of these transitions. The potential impacts on the Transfer Pricing practice will be examined below.

Taking into account the timeframe for the transition from the IBORs to the ARRs, it is important to identify and analyze the impact of the transition to risk-free rates ('RFRs') to lenders and borrowers alike.

Overview

In the United Kingdom ('UK'), the Bank of England has been working to ensure a transition from LIBOR to the Sterling Overnight Index Average ('SONIA'), a rate produced by the Bank of England. SONIA reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions and other institutional investors.

Moreover, in the Euro area, there is a drive to replace both the EURO LIBOR and Euro Interbank Offered Rate ('EURIBOR') by the Euro short-term rate ('€STR'), which is calculated on the wholesale euro unsecured overnight borrowing costs of euro area banks.

In addition, in the US, the Alternative Reference Rates Committee (ARRC), convened by the US Federal Reserve, has published its Recommended Best Practices for Completing the Transition from LIBOR. The Secured Overnight Financing Rate ('SOFR') is the recommended ARR for replacing the USD LIBOR. SOFR represents a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities.

General differences

There are a number of differences between IBORs and ARRs. The first main difference between them is that IBORs represent the rate at which banks believe they are able to lend to and from one another in the interbank market over a specified time period, whereas ARRs typically refer to overnight transactions. Another main difference is that IBORs typically include an element of risk in the form of a credit spread, where RFRs are effectively nearly risk-free rates.

General Transfer Pricing considerations

Immediate focus should be given to intragroup financing transactions considering that IBORs have often been used as underlying rates for intragroup financing arrangements. Considering that for tax purposes transactions entered between related parties (including financial instruments) should be concluded on arm's length terms, such arm's length price may have been specified by reference to IBORs (e.g. LIBOR plus a margin).

Following the replacement of the IBORs by ARRs, the terms of both intra-group financing arrangements may need to be reassessed and such terms are expected to be on at arm's length as at the reassessment date.

Based on the above, taxpayers should determine whether a financial instrument that is amended as a result of the benchmark reform constitutes a variation or rescission of the original financial instrument. This should also be considered in the light of fallback provisions if applicable in the initial loan/facility agreement. By way of example, the discontinuation of an IBOR referenced in a loan facility and its replacement by an agreed alternative benchmark may result in changes to the amount payable under the facility. It is unclear how the increase in the loan amount will be treated for tax purposes.

In addition, the appropriate ARR should be selected for each financial instrument (i.e. in line with guidance from relevant associations, tax authorities etc.). Another implication that should be considered is the potential adoption of timing differences between jurisdictions as well as differing views on the acceptability of each ARR. Such deviations may result to a mismatch of acceptable rates and/or their treatment from a tax perspective in each jurisdiction.

Depending on the circumstances, the transfer pricing documentation of such financial instruments may need to be updated in order to reflect the change from IBORs to ARRs and/or new documentation should be prepared in order to support the financial agreements to be entered into from an arm's length perspective.

More specifically, considering the Transfer Pricing Circular issued by the Cypriot tax authorities applicable as of 1 July 2017, where for example, a third-party financing institution is involved in the provision of variable interest rate financing (with an IBOR used as the floater) to a Cypriot financing entity that uses the loaned funds to grant variable interest rate financing (with that same IBOR used as the floater) to related parties, the intragroup use of IBOR may need to be investigated. The financing institution may amend the respective ARR based on a fallback provision included in the existing agreement, effectively exposing the group's financing vehicle to additional risks due to the floater rate mismatch.

The impact of the transition is not restricted to typical lending transactions, but it has a wider impact. For example, currency derivatives will also be affected (the ISDA Benchmarks Supplement may be incorporated in derivatives transactions).

Finally, consideration should be given in cases where a taxpayer has obtained advanced pricing agreements ('APA') or rulings regarding specific intragroup transactions, as the applicability and/or validity of an APA or ruling may be challenged due to the discontinuation of the relevant IBOR or lack of acceptability of the underlying IBOR.

Takeaway points

There still remains a high degree of uncertainty around LIBOR transition. The transition could have a number of impacts on market participants. These impacts include possible changes to contractual documentation, adaption of operational processes/IT systems, changes to the value of products or the possibility of products no longer serving the purpose for which they were intended. Interesting parties should contact their professional advisors on the possible implications of the changes such as financial, legal, accountancy or tax consequences.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.