The financial services industry in the last year has been heavily impacted by two main transfer pricing challenges: the COVID-19 pandemic and the Interbank Offered Rates (IBORs) transition. Those changes could impact the tax position of multinationals in the financial industry since they are likely to drive tax controversy across jurisdictions in the next years.
IBOR reform
The financial services industry is facing an unprecedented contract review and repapering exercise due to the regulatory mandate to transition away from Interbank Offered Rates (IBORs) to alternative Risk-Free Rates (RFRs).
The Euro Interbank Offered Rate (EURIBOR), the London Interbank Offered Rate (LIBOR), the Euro Overnight Index Average (EONIA) and certain other Interbank Offered Rates (IBORs) have been used extensively as a reference rate in a range of financial products and instruments for more than 40 years. With the heightened risk of imminent discontinuation of IBORs, financial market participants are accelerating their efforts to transition to alternative RFRs. This transition is expected to be one of the most significant changes for the financial services industry.
By the end of 2021, firms are required to transition from IBORs to alternative RFRs. As the endgame nears, and banks progress in their transition, various key pieces still require positioning by end of 2021. The adoption of alternative rates in new products is underway but a lot of work remains to be done to ensure that IBORs are no longer the reference rates of default used when preparing transfer pricing documentation.
As the end of 2021 nears, we will try here to give some clarity on the path to IBOR transition from a transfer pricing standpoint.
The Luxembourg transfer pricing rules require the application of the arm’s-length standard for transactions, including financial instruments, between related parties. Profits of associated enterprises entering into transactions that do not meet the arm’s length principle will be determined according to normal market conditions and taxed accordingly.
Historically, the arm’s length price of financial instruments might in many cases have been specified by reference to IBORs. For example, the arm’s length interest rate charged on intra-group loans may have been based on LIBOR plus a margin.
Moreover, there may also have been references to IBORs used to decide on the arm’s length price of non-financial contracts.
The Luxembourg Tax Authorities would normally accept that parties to a contract that references IBORs would, acting at arm’s length, agree to make changes to the contract to respond to the reform of the benchmark.
It would not normally be necessary to reassess whether the terms of the original agreement are arm’s length as this is tested at the inception date of the financial instrument. However, in accordance with the best practice and most prudent approach we recommend multinational groups to update their transfer pricing documentation to reflect the withdrawal of IBORs, making sure that any amendments to financial instruments between associated enterprises are undertaken on an arm’s length basis.
In this respect, a detailed review of the contractual arrangements would need to be performed to ensure that such amendments would not be considered as a taxable event at the level of the lender.
Moreover, in the assessment of impacts on banks’ operating models in a dual-rate environment during the transition when IBORs and alternative RFRs are expected to co-exist, critical transfer pricing points will be the internal funding arrangements and funds transfer pricing (FTP). We also consider necessary to revisit these models in order to reflect the dual-rate environment in the pricing of the liquidity when using maturity transformation to increase the interest margin.
COVID-19
The escalating unprecedented COVID-19 crisis spread rapidly in FY 2020 and increased uncertainty globally. In the Luxembourg banking sector, in particular, it expressed itself in cash flow shortfalls caused by lower operational results that forced financing institutions to access additional financing and redistribute cash within their groups and in an increased credit risk environment as borrowers of financial institutions face substantial financial stress during the COVID-19 outbreak increasing their risk of default.
Moreover, the COVID-19 crisis has caused higher financing costs due to increased credit risk, extraordinary losses as many taxpayers had to bear extraordinary expenses due to credit, foreign exchange, interest rate and investment risks materializing.
Finally, a revision of intercompany agreements was necessary considering that the COVID-19 outbreak has highlighted that many contractual obligations cannot be fulfilled in intra-group situations.
The COVID-19 crisis is imposing challenging times in many different business areas and transfer pricing does not constitute an exception. As prices come under pressure from third parties or risk premiums are imposed, group enterprises should also reflect those changes in the pricing of their intragroup transactions.
When making a transfer pricing risks assessment there are different questions that might be raised by the Tax Authorities:
- Have changes related to the allocation of people functions during COVID-19 been monitored?
- Whether and how should project costs related to COVID-19 be allocated amongst group entities?
- Do legal agreements/internal policies include coverage of extraordinary items like COVID?
- Were losses generated during COVID shared amongst group?
- Which are the effects of COVID on FTP?
In summary, in our view the above-mentioned points for IBORs transition and COVID-19 pandemic are the key transfer pricing points currently. Addressing them, together with ensuring an accurate transfer pricing analysis and a proper transfer pricing documentation globally, will be the necessary measures to be taken to prevent transfer pricing and tax controversies.
The article has been published in AGEFI
