The London Interbank Offer Rate (‘LIBOR’) will cease to be in effect from 31 December 2021. It is hard to overstate the importance of the transition away from the London Interbank Offered Rate (LIBOR), nor its current significance within the global financial system. Currently LIBOR is the benchmark for over US$350 trillion in financial contracts worldwide, the impact of the transition from LIBOR will be far-reaching for financial services firms, businesses and customers alike.
The Alternative Risk-Free Rates (ARRs) that have subsequently been agreed upon and will replace LIBOR from 1 January 2022 include SOFR (Secured Overnight Financing Rate) for USD, SONIA (Reformed Sterling Overnight Index Average) for GBP, €STR (Euro Short-Term Rate) for EUR, SARON (Swiss Average Rate Overnight) for CHF and TONAR (Tokyo Overnight Average Rate) for JPY. All these new benchmark rates are currently being published in the public domain in their respective platforms concurrently with LIBOR.
What does this mean for Tanzania? Well, although the Tanzania financial market is still at an infancy stage compared to advanced markets nevertheless there are enough contracts which use LIBOR to warrant attention. Those impacted will include financial institutions (such as banks, insurance, reinsurance firms), Government (given the borrowing in hard currencies) and large corporates (many of whom have funding in foreign exchange). Given the extent of the impact, planning locally for the transition should have started several months ago. So what is it that needs to be done?
Firstly, businesses should stop signing new contracts which use LIBOR as a benchmark. This will minimise avoidable complications during the transition phase. In some jurisdictions, regulators enforced cessation of the use of LIBOR in newly originated contracts more than a year before the official end date. If circumstances dictate that LIBOR must be applied on a new contract, then a fallback clause must be included which clearly stipulates a new reference rate once LIBOR ceases to exist.
Secondly, all existing LIBOR indexed contracts must be identified for the purpose of engagement with the counterparties on the new rate. Potential risks from LIBOR transition must be established and mitigation measures discussed thoroughly. It is expected that none of the new rates will precisely mirror LIBOR; therefore, it is imperative that affected parties understand the proposed benchmarks and so boost negotiation muscles with the counterparties. Where necessary and applicable, appropriate tailored training should be organised for key stakeholders. If the transition process is mismanaged, the risk is that one of the counterparties to a LIBOR contract may suffer material losses while the other receives windfall gains.
The transition also has wider legal, accounting and tax implications that need to be considered.
From a legal perspective, consideration should be given to the review of legal contracts and how to address the proposed reference rate transition in the said contracts. Legal contracts, in this case, refers to active contracts that are due to mature past 2021 and that require unanimous consent to amend provisions deemed essential to the contract.
In certain instances, the accounting ramification of the transition will be a significant change in the basis for determining cash flow and potential consequent derecognition or modification of financial instruments. The detailed conditions to be considered are set out in the relevant accounting standard (International Financial Reporting Standard (IFRS) 9). Where there is such a change, the disclosure in the financial statements will have to be enhanced in order to capture the impact of the change.
Tax complications will also arise in particular in relation to transfer pricing implications for multinational enterprises (MNEs) with intercompany financing arrangements tied to LIBOR. Under transfer pricing rules, intercompany loans need to be priced contemporaneously and on an arm’s length basis. The change will require MNE’s to determine and support proper spread adjustments over the new reference rates which are different in risk profile and term structure (this approach is currently proposed by two market regulators (i.e. ISDA and ARRC).
The differences in information contained in LIBOR and new reference rates including the changes in risk profile will create comparability differences and therefore challenges for companies currently using LIBOR base rate as a benchmark. MNEs therefore should reassess their transfer pricing policies.
Whilst global standard setting and regulatory bodies within the tax and accounting industries have reviewed their regulations and standards to provide guidance, there is also space for local regulators to play their part in supporting a timely and clear implementation roadmap to enable robust transition.
All parties affected should remember that inaction could be extremely costly, but with 31 December 2021 just around the corner the time for action is running out fast.
By Cletus Kiyuga, Assurance Partner – PwC Tanzania.