By Dr. Harold McClure, New York City
The Australian Taxation Office (ATO) began a dialogue with representatives of multinationals on how to address the transfer pricing implications of the demise of London interbank rates in a paper dated August 12. This article uses an example that is described in the ATO document to further illustrate the problem.
The publication of the London interbank rates is expected to cease after December 31, 2021. Since many third party and related party variable rate loans use these rates as the base rate, an alternative base rate will be required for existing loans, because as well as loans issued in the future.
Business-to-business loans usually have either a fixed interest rate or a variable rate. Variable rate loans are also called variable or adjustable rate loans. Variable rate loans are expressed in terms of the base rate plus a loan margin, with the interest rate varying over time with changes in short-term market rates.
As an example, consider a mortgage agreed in early January 2016 to pay the rate on a one-year U.S. government bond plus a margin equal to 1.5%. Back then, the interest rate for one-year government bonds was only 0.6%, so the interest rate for the first year was 2.1%. The rates on government bonds on the anniversary date were 0.9% for 2017, 1.8% for 2018, 2.6% for 2019, 1.5% for 2020 and 0.1% for 2021. The adjustable rate mortgage contract would set the interest rate at 2.4% for 2017, 3.3% for 2018, 4.1% for 2019, 3.0% for 2020 and 1.6% for 2021 .
Variable rate loans often use the offered interbank rates as a benchmark. The London Interbank Offered Rate (LIBOR) has often been used as the benchmark rate. LIBOR rates are currently quoted for loans denominated in US dollars, British pounds, euros and Japanese yen and used for loans quoted in other currencies, including the Australian dollar. LIBOR rates are shown for loans denominated in US dollars for which the rate changes monthly, quarterly, six months and annually.
In early January 2016, the 12-month LIBOR rate for US dollar denominated loans was 1.15%, which was 0.55% spread over the one-year government bond rates. If the B2B loan had been set up with 12-month LIBOR as the base rate and a 0.95% line of credit, the initial interest rate would still have been 2.1%.
The “TED spread” is formally defined as the difference between the 3-month LIBOR rate on loans denominated in US dollars and the interest rate on 3-month US Treasury bills. The above 0.95% difference between the 12 month LIBOR rate and the 1 year government bond rate can be seen as a longer term version of TED spreads. Similar TED spreads can be calculated for currencies other than the US dollar.
Credit spreads for fixed interest rate loans are defined as the difference between the interest rate on corporate bonds and the interest rate on government bonds for the same currency and the same term to at the due date. For floating rates where the base rate is an interbank rate, the sum of the TED spread and the loan margin can be considered as the credit spread.
The ATO document of August 12 presented several examples of intercompany loans from an Australian parent company to a UK subsidiary where the UK subsidiary incurred intercompany debt denominated in pounds sterling with an interest rate equal to the 3 month LIBOR rate plus a margin. loan of 5%. Each of these examples looked at how the loan terms were changed after December 31, 2021.
The following table examines the pricing of two intercompany loans, both issued in early January 2019. One was granted to a UK subsidiary and was denominated in pounds sterling, while the other loan was made to a US subsidiary and was denominated in dollars. The following table presents some market data to determine the credit spread implied by a 5% loan line.
Two hypothetical business-to-business loans
The 5% line of credit in the ATO example is surprising in light of the intercompany contract at issue in Chevron Australia Holdings Pty Ltd v. Commissioner of taxes. The tax court ruling described the business-to-business loan agreement:
Central to the proceedings is a credit facility agreement dated June 6, 2003 between CAHPL and ChevronTexaco Funding Corporation (CFC) under which CFC agreed to make advances from time to time to CAHPL “in total the equivalent in Australian dollars… two billion five hundred Million US dollars ”. Interest was payable monthly at a rate equal to “1 month AUD-LIBOR-BBA as determined for each interest period + 4.14% per annum” and the final due date was June 30, 2008 (the credit facility agreement).
The ATO disputed the 4.14 percent line of credit and successfully argued that this line of credit should have been less than 1.5 percent.
LIBOR rates were quoted in Australian dollars until 2013, but have not been since. However, interest rates on interbank loans denominated in Australian dollars are still being reported. The interest rate on 3-month Australian dollar-denominated interbank loans was around 2% at the start of January 2010. Similar US rates were higher, while similar UK rates were lower.
The TED spread for loans denominated in US dollars was 0.42 percent. If our intercompany loan had been denominated in dollars with this 5% line of credit, the interest rate would have been 7.8%. As such, the credit spread would have been 5.42%.
The TED spread for sterling denominated loans was 0.18%. If our intercompany loan had been denominated in pounds sterling with this 5% line of credit, the interest rate would have been 5.91%. As such, the credit spread would have been 5.18%.
In the absence of declared LIBOR rates, another base rate must be found. A simple solution might be to use Treasury bill rates as the base rate, with the loan margin equaling the credit spread. Our hypothetical intercompany loan could have been expressed as the Treasury bill rate plus a loan margin close to 5.2%.
We will note three caveats. The most important transfer pricing question for this example is whether a credit spread greater than 5% could be maintained at arm’s length. The ATO challenged high credit spreads based on assumptions of low credit ratings in situations where the related borrower was an Australian subsidiary. In this example, the related borrower is a UK subsidiary. It is likely that the UK tax authorities would challenge a credit spread of over 5%.
The second caveat is that TED spreads vary over time. The US TED spread fell from over 0.4% in early January 2019 to less than 0.1% in mid-August 2021.
Finally, we would have to report Treasury bill rates to perform our simple LIBOR replacement. While the Federal Reserve publishes rates on US Treasuries, the Bank of England recently stopped publishing rates on UK Treasuries.