Global financial authorities have agreed to stop using the London Interbank Offered Rate (LIBOR) as a benchmark interbank lending rate by the end of 2021. The business world needs to anticipate the matter, especially its impact on financial transactions between affiliated companies.
This decision was taken by the Financial Stability Board (FSB) formed by the G20, the FSB, following the expose of the LIBOR interest rate manipulation scandal carried out by Barclays almost a decade ago.
The world's fourth-largest bank has been proven to manipulate its benchmark interest rate for its own benefit.
Worst of all, this deceptive practice was carried out when the world was hit by a severe financial crisis (2007-2009).
For the misconduct, Barclays was fined USD450 million. This scandal also made Marcus Agius fired from his position as Chairman and forced Bob Diamond to resign from the CEO position.
LIBOR is the interbank lending rate on the London money market, which has been a benchmark for global financial transactions for nearly four decades. To be precise, LIBOR has been the official benchmark for interbank lending rates since 1986.
This daily reference rate is published by the International Exchange Benchmark Administrator (IBA)—under the supervision of the British Bankers Association—based on the analysis of lending rates reported by 16 giant banks, such as Barclays, Citibank, JP Morgan, HSBC, and UBS.
Every day, IBA announces LIBOR figures for seven types of loans distinguished by the period of return (tenor)—from overnight to one-year loans—and covers various types of the world's major currencies, such as the US dollar, euro, pound sterling, yen, and Swiss franc.
Alternative Interest Rate
Learning from the Barclays scandal, FSB considers LIBOR is no longer credible to be used as a daily rate reference since it is vulnerable to manipulation practices.
The reason is, for more than a decade, the determination of LIBOR no longer refers to the active underlying market, but is only supported by perceptions or "expert judgments".
The crisis of trust in LIBOR also led several monetary authorities to set alternative benchmark interest rates.
Some that have been introduced to the public include Secured Overnight Financing Rate (SOFR) for USD, Sterling Overnight Index Average (SONIA) specifically for pound sterling, Euro Short Term Rate (€STR) for euro money, Swiss Average Rate Overnight (SARON) for Swiss franc, and Tokyo Overnight Average Rate (TONAR) specifically for Japanese yen.
Bank Indonesia has also introduced the Indonesia Overnight Index Average (IndoNia) as the benchmark rate for the national money market since 2018.
The moment of shifting from LIBOR to an alternative benchmark interest rate will make the business world face a significant transition, especially regarding financial transactions.
In the context of transfer pricing policies, business groups and their affiliated companies need to consider the impact that may arise from the LIBOR rate change transition, especially related to intercompany agreements affected by the termination of LIBOR.
As the first measure, companies can begin to identify LIBOR-based transactions and revise affected agreements to align contract terms with actual conditions.
By the end of 2021, the business groups and their affiliated companies need to immediately identify LIBOR-based financial transactions with a maturity period beyond 2021.
Furthermore, the parties shall revise the terms of the contract on the transaction to respond and align with the latest actual conduct, (e.g., the latest interest rate, payment table, etc.)
In response to this transition period, several international financial associations have also prepared a draft of fallback texts that may be used by companies in their revised contracts.
Arm's Length Principle Analysis
The business groups and their affiliated companies also need to consider the impact of this transition on the analysis of the arm’s length nature of their financial transactions,
including the determination of the arm’s length interest rate when the fiscal year 2021 ends.
It should be noted that LIBOR and alternative benchmark interest rates have significant characteristic differences in terms of tenor, guarantee, and time of determination perspective.
In terms of tenors, for example, LIBOR publishes its issuances into seven types of tenors, while the alternative benchmark interest rates only publish tenor issuance in the overnight period.
These comparability differences illustrate that LIBOR and alternative benchmark interest rates are not identical, so they cannot be directly substituted.
Consequently, the analysis of arm’s length nature of financial transactions beyond 2021 must be re-evaluated in order to produce an arm’s length interest rate calculations that are consistent with the arm's length principles.
Re-evaluation of the analysis of the arm’s length nature and transfer pricing policy must take account of domestic regulations.
In order to stay in line with the transfer pricing provisions in Indonesia, business groups and their affiliated companies must ensure that the revisions to financial transaction arrangements are contemporaneous and still keep an eye to the test on the existence, the substance of loans, and special rules related to thin capitalization.
Any company's planning measures in facing this transition are expected to mitigate transfer pricing risks in the future, and ensure a good transition to substitute benchmark interest rates or other substitute variables.
*The article was published in?Kumparan.com, on 13 October 2021