I wrote an article on the IBOR transition from a South African perspective about a year ago. The article focused on what “IBOR transition” means and on how to get ready for it should you have active arrangements referencing IBOR. You can find the article here.
From earlier this year some IBOR rates are no longer published. The big example is USD LIBOR, which many have referenced to provide for an interest rate in their agreements. Let’s assume we still have agreements in place as of right now that reference USD LIBOR but as this is no longer published, how do I determine my interest rate. This also assumes the agreement does not have another rate to use in case USD LIBOR is no longer available. The below are some points to consider from a transfer pricing perspective. There are potential other tax consequences that may also arise from this but I have tried to stay clear of those, as it can be a lot to digest in one blog post.
One of the more important factors to consider is if the change of the reference rate (i.e. USD LIBOR) to another rate such as SOFR results in a variation or a rescission of the agreement. In other words, is the contract amended but continued, or is the contract cancelled and the parties are returned to the position they were in before entering into the agreement and a new one is entered into. If the agreement is considered rescinded there are more issues to consider. From my research on this it seems that a change of the reference rate is expected to be a variation of the agreement and not a rescission. Interestingly, one cannot just swap an IBOR rate with a risk free rate (RFR) and keep the spread the same as the two rates are not comparable. More on that a bit later though.
One question we need to always answer in transfer pricing is if the change in an agreement (contractual term) is aligned to a change that a third party would do. Ignoring the interest rate percentage, this seems very obvious here and as you have guessed there isn’t much of a transfer pricing concern whether the variation of the term in relation to the interest rate is acceptable. Banks have been doing this already and there is support for this. If there is a rescission of the agreement this would play out very differently, but I have ignored that here as it is unlikely to be the case.
This may also seem obvious but as always, any variation to the terms of an agreement which have a material impact on your transfer pricing should be be supported through commercial rationale and the appropriateness of approach applied included alignment with factors should be documented in line with local transfer pricing rules. But that is enough on the compliance part.
Let’s jump to the tricky transfer pricing part. How do I price my loan which previously has referenced USD LIBOR as the rate is no longer published? The short answer is, use the IBOR Fallback Rate. The long answer is in the pictures below. I copied these pictures from Bloomberg and you can find the paper here. The paper has some great points and if you are considering the Fallback Rate, this is a must read.
Trying to put this in my own words, you will need to determine an adjusted reference rate (ARR). This could be done by considering a RFR such as SOFR for USD denominated loans. However, keep in mind SOFR is an overnight rate and similar to other RFRs you may need to do some compounding to account for the time difference to get to something similar to a 3-month LIBOR (for example). Once you have the ARR you would need to consider what the spread should be in addition to the ARR. As there are some differences in an IBOR to a RFR it is unlikely that you can just apply the same spread as per the previous agreement. Just to scare you a little with maths, because that is what happened to me the first time I saw this, I thought I share the two equations in relation to the ARR and the spread adjustment (SA) below.
So does that mean you now have to study maths to be able to calculate the Fallback Rate? Luckily not! Most loan/bond type terminals such as Bloomberg or Refinitive have an application that can run this for you.
I know the above is a lot to take in, but if you take anything away from this post, let it be the following. If you still have a loan agreement in place that refers to IBOR, change the reference as soon as possible and use a new reference such as the RFR. You can still use the Fallback Rate now, but this may also come to an end and you don’t want to be stuck with no alternative.