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5 Things to Know About Transfer Pricing and the LIBOR Transition

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With the London Interbank Offered Rate (LIBOR) being replaced by risk-free rates this year, taxpayers should review their transfer pricing agreements and documentation. Learn about five steps organizations should take as they consider transfer pricing and the LIBOR transition.

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The London Interbank Offered Rate (LIBOR) historically has been used as a key benchmark for a range of financial instruments and contracts with variable interest rates. Due to evidence of manipulation and other issues over the past decade, however, LIBOR is being discontinued, with the publication of non-U.S. dollar-denominated LIBOR rates concluding on Dec. 31, 2021.1 In anticipation of the transition, certain stakeholders, such as industry-specific working groups and regulators, have identified alternative risk-free reference rates (RFRs) to replace LIBOR. These stakeholders, such as the Alternative Reference Rates Committee (ARRC) in the U.S., are responsible for overseeing the transition to each individual RFR.

Working groups and other relevant authorities, such as the International Swaps and Derivatives Association (ISDA), have released specific guidance to assist organizations with updating contracts affected by the transition, including updated fallback language to be used in the event that the selected benchmark rate is permanently discontinued or is otherwise determined to be nonrepresentative of its underlying market.

Due to its widespread use and versatility, LIBOR often is embedded throughout an organization’s operations (such as in legal agreements and internal financial models) and, accordingly, companies must be proactive about addressing the LIBOR transition and identifying any associated risks. The LIBOR transition has broad implications. While these changes might be only one of many issues on a list of competing priorities for most organizations, they have the potential to affect a number of existing functions including, for tax purposes, the arm’s-length nature of certain intercompany transactions or arrangements (for instance, a loan from a parent to a subsidiary with an interest rate based on LIBOR plus a margin).

As a result of transitioning from LIBOR, taxpayers should review their transfer pricing analyses and associated support to determine if any updates are necessary, including whether to prepare revised transfer pricing documentation or agreements. Following are five steps companies should consider from a transfer pricing perspective.

  1. Identify LIBOR exposure

Organizations should review if their existing intercompany agreements or contracts reference LIBOR. In some cases, formal agreements or contracts might not currently exist, though LIBOR may still be used as basis for important determinations such as determining the interest rate on an intercompany loan. Companies also should consider formally memorializing intercompany arrangements and terms that have not previously been formally documented in light of the LIBOR transition.

  1. Determine the appropriate RFR to replace LIBOR

If a LIBOR exposure is identified, companies should review the available alternative RFRs, understand their individual characteristics, and identify how current arrangements would be affected by each. RFRs have distinct characteristics and are overseen by different administrators, so organizations should review the information released by the relevant authorities to determine the appropriate rate to replace LIBOR.

  1. Consider the tax and transfer pricing implications of transitioning to an RFR

It is important to understand the potential tax and transfer pricing implications inherent in transitioning to a new RFR before finalizing amended intercompany agreements. In October 2020, the IRS released Revenue Procedure 2020-44, which states that modifications to contracts to incorporate specific ISDA or ARRC fallback language will not cause certain adverse tax consequences. However, the IRS has not released any guidance under the transfer pricing regulations that would provide similar protection from a transfer pricing adjustment.

Due to the lack of guidance, additional transfer pricing analyses might be required to substantiate the arm’s-length nature of intercompany transactions affected by the LIBOR transition (such as loans). Organizations should consider whether they should do any of the following:

  • Update loan analyses to account for changes in interest rate and/or market conditions.
  • Update the credit analyses to incorporate new RFR and spread adjustment.
  • Document economic analyses to substantiate the arm’s-length nature of the RFR and its equivalence to LIBOR.
  • Perform comparability adjustments to benchmarks to account for the differences between LIBOR and the RFR (for example, secured versus unsecured).

To avoid potential risk exposure, any changes or modifications to intercompany agreements or transfer pricing analyses ultimately should reflect arm’s-length terms (terms that third parties would agree to with one another).

  1. Amend intercompany agreements

Once LIBOR exposure has been identified and an alternative RFR has been selected, organizations should amend any intercompany agreements that reference LIBOR. For derivative products, companies should reference the fallback language and guidance released by the ISDA that would specify the agreed-upon actions to address LIBOR’s discontinuance. For cash products (such as floating rate notes and bilateral business loans) companies should reference the guidance or specific fallback language released by the working group responsible for overseeing the transition to each RFR (for example, ARRC).

  1. Document changes

After all LIBOR-related changes have been made, companies should document these changes, which might include a summary of contracts affected by the LIBOR transition and remediation plans, any analyses performed to identify LIBOR-based risk, the changes required for adoption of the RFR (such as updates to pricing, valuation and risk models, or interest-rate hedging), and other relevant internal changes made to accommodate the LIBOR transition (like IT system changes). Due to the lack of guidance from tax authorities on the transfer pricing implications of this transition, any changes that affect intercompany pricing or agreements should be well documented.

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1 Publication of certain U.S. dollar-denominated LIBOR will continue until June 30, 2023.