The end of LIBOR – what’s next? The end of LIBOR – what’s next?

The end of LIBOR approaches. While for EUR denominated loans, one can already rely on term rates that will stay after the LIBOR phase out, in other instances a more pragmatic approach will be required to replace the currently used term reference rates.

As announced by the ICE Benchmark Administration (“IBA”), LIBOR will be discontinued as of 31 December 2021. Therefore, starting from 2022 almost all LIBOR rates (with the exception of USD LIBOR, which will continue until June 2023) will no longer be published. 

For further information on what the LIBOR discontinuance entails and what impact it might have on companies, please refer to our previous post here.

Current alternatives to LIBOR
Following the communication of the LIBOR discontinuance, alternative risk-free rates (“RfRs”) have been introduced for various currencies.

Such RfRs, however, are mostly published as overnight rates and due to the lack of liquidity on their derivative markets this situation will likely persist for the foreseeable future. This is a major change compared to the LIBOR rates that are published in various terms (e.g. 1 month, 3 months, etc.).

In order to account for different terms even with RfRs, it is possible to calculate compound rates. This can be accomplished in two ways:

1. Ex-post approaches. The general guidance is to follow one of the ex-post approaches, which implies calculating the compound rate of a certain period of time (e.g. 3 months) by looking back at the actual daily overnight rates and calculating a 3-month compound rate; and
2. Ex-ante approaches. The ex-ante approaches lead to less precise results but has the benefit of providing certainty on the interest rate to be paid in a future period.

As one group (i.e. the ex-post approaches) is based on actual results while the other (i.e. the ex-ante approaches) is based on market expectations, there will likely always be divergences between the two results.

US Dollar (IRS Guidance)
Further guidance is provided by the Internal Revenue Service (“IRS”), in the United States. Although, as mentioned, the publication of the USD LIBOR has been extended to 30 June 2023, the IRS has provided some guidelines in relation to the use of alternative RfR. 

According to the IRS Guidance, the new RfR must meet the definition of a ‘‘qualified rate’’ which includes any rate endorsed by a central bank or similar authority, as long as the currencies of the original and replacement benchmarks match. 

One additional criterion for a qualified rate is that the fair market value of the financial instrument post-modification must be ‘‘substantially equivalent’’ to its fair market value prior to the modification. Alternatives for fair market compensations for ongoing loan agreements include:

• One time payments;
• Change in timing and frequency of interest payments;
• Margin adjustment;
• Safe-harbor rule: For related-party instruments, a replacement rate is qualified if, on the date of modification, the historic average of the LIBOR-based rate does not differ from that of the replacement rate by more than 25 basis points (taking into account any one-time payments).

As of June 2021, it is not yet clear when term Secured Overnight Financing Rate (“SOFR”) (i.e. the alternative USD RfR) rates will be published.

Swiss Franc
The official position of the Swiss National Working Group (“NWG”) is that “a forward-looking Swiss Average Rate Overnight (“SARON”) term rate would have to be based on the SARON derivative market, which is not liquid enough. Having a sufficiently liquid underlying market is a core requirement for determining robust benchmarks.”

Although this market is expected to become more mature, it is unlikely that the bulk of transactions will match the maturity of the forward-looking SARON term rates desired to be constructed. Such circumstances would thus require a rather complex methodology for term rate construction. 

Consequently, the NWG stated in its October 2018 meeting that a forward-looking CHF term rate was currently not feasible and compounded SARON should be used instead. 

Euro
Regarding the Euro, the European Central Bank has already been publishing term rates for the Euro Short-Term Rate (“ESTER”).

Other currencies
For currencies other than USD, EUR, GBP, JPY, CHF, it is still uncertain how the transition should be managed. 

It is reasonable to assume that these currencies will have to rely for a longer period on calculations based on RfRs, with the respective term adjustments.

What to do with financing agreements?
In case financing agreements are in place which are linked to LIBOR, there are various approaches that could be applied to deal with the transition.

If such agreements expire before 31 December 2021, no action will be required.

In case financing agreements are signed after 31 December 2021, or have an interest update starting from 1 January 2022, two options can be considered:

1. a new agreement is signed in 2022, which makes reference to the new RfR instead of LIBOR; or 
2. a switch is made from LIBOR to the new RfR. 

What can you do?
Companies should ensure they have an overview of their current financing agreements, as well as a strategy in place to deal with those that do not expire before 1 January 2022. 

Should some financing agreements based on LIBOR be valid beyond 31 December 2021, then one should implement one of the solutions previously outlined and verify what the potential tax consequences are.

From a practical perspective, most of the companies not involved in the financial sector will likely not experience a material impact from a transfer pricing point of view. Nonetheless, there is still a difference between the two rates (i.e. LIBOR and new RfRs) and it is important for companies to manage this transition carefully