By David Early, Partner | Nuwaru | Corporate and International Tax
The Reforms
For many years inter-bank offered rates, or IBORS, and in particular, the London inter-bank offered rates, or LIBOR, have been a widely used benchmark for global interest rates, underpinning derivatives, loans, bonds, and other financial products.
Following the financial crisis in 2007-2008, several weaknesses in LIBOR became apparent. Some market participants had, for many years, been manipulating LIBOR to benefit their financial institutions. Although benchmark reforms and regulations addressed this, concerns remained, and regulators globally determined that LIBOR would be unreliable beyond 2021, and markets would need to transition to more robust and reliable market-determined interest-rate benchmarks. Consequently, IBORs began transitioning to alternative nearly risk-free rates (RFR), and LIBOR ceased to be published in a number of currencies at the end of 2021.
For AUD contracts, the interest-rate benchmarks are BBSW and the RBA inter-bank overnight cash rate. The cash rate is considered the RFR for AUD. Reforms have been made to enhance the robustness of these benchmarks, including strengthening the methodology underlying the calculation of BBSW. Accordingly, both rates will continue to co-exist as the key benchmarks for AUD.
Why Should This Concern Me?
As many financial arrangements reference IBORs (mainly LIBOR), this transition has necessitated the need to review the terms of contracts for financial arrangements, and where the contracts reference an IBOR, a modification (or rescission of contracts) to replace the references from the existing IBOR to a relevant RFR, and other consequential amendments.
The modifications to such contracts may trigger tax consequences, particularly if they give rise to the rescission of the original contract and creation of a new contract.
If the financial arrangement does not reference an IBOR (e.g. it is denominated in AUD and references BBSW or the cash rate), then generally, modifications to the contract should not be required.
Tax Consequences
The tax consequences will vary depending on whether there is a continuation of the original contract, or the rescission and creation of a new contract. Modifications or rescissions of contracts will be determined by the facts and circumstances of each case.
The ATO has indicated that where the parties agree to change the contractual terms for the sole purpose of responding to the withdrawal of LIBOR, it expects that in most cases this is likely to be characterised as a variation of the contract rather than the rescission and creation of a new contract.-For example, the simple replacement of LIBOR for an RFR and other directly consequential amendments may be used to maintain the legal and economic substance of the arrangement.
Where the contract contains a fall-back provision (i.e. a clause that determines which rate the parties should use if the initially agreed upon benchmark is no longer available), this should not in and of itself be regarded as a variation to the contract, nor of course, a rescission of the contract. However, the fall-back provision may result in an inappropriate rate going forward–as it may reference the last LIBOR before LIBOR ceased. This would necessitate an amendment to the contract to maintain the commerciality of the rate and ensure transfer pricing issues do not arise.
Continuations of Existing Contracts
The changes to a contract may result in a different spread and rate, consequential true-up adjustments, or even revisions to the terms of the contract.
Where the taxpayer is subject to the Taxation of Financial Arrangements (TOFA) regime, and has elected to rely on financial reports, the income tax consequences should follow the accounting treatment of such adjustments. The amendment to the contract may trigger the requirement to recognize a credit or debit adjustment in the profit and loss, and as such a matching taxable gain or loss.
Where the taxpayer is subject to the TOFA regime but has not made any elections to apply TOFA tax-timing methods, the taxpayer may need to reassess or re-estimate its financial arrangement under the default accruals/realization methods. For a loan, this may involve a change to the quantum of interest income or expense recognized on a compounding accruals basis over the remaining term of the loan. Naturally, this may trigger tax consequences.
Where the taxpayer is not subject to the TOFA regime, the impacts under the ordinary income and deduction provisions will need to be considered, and potentially Division 16E for a qualifying security (e.g. a discounted security). In the case of an ordinary loan, the changes to the interest rate will result in a consequential change to the quantum of allowable deductions for accrued interest payable, or interest income derived on receipt (or reinvestment). Any true-up payments will also likely be assessable upon receipt, or deductible when payable.
The Rescission of Existing Contracts
Where the taxpayer is subject to the TOFA regime, the rescission of the contract results in the early termination of the financial arrangement, triggering a potential balancing adjustment.
Where the taxpayer is not subject to the TOFA regime, the early termination of the contract may result in a realization event (e.g. FX gain or loss on foreign currency denominated loan), or disposal of a security, triggering an assessable gain or deductible loss. Depending on the nature of the financial arrangement, such an assessable gain or deductible loss may arise under either the ordinary income or deduction provisions including:
- Section 6-5 or 8-1
- Division 775 (about foreign currency gains and losses)
- Sections 26BB/70B (applying to traditional securities)
- Division 16E (applying to other qualifying securities)
- CGT provisions (e.g. CGT event C2 on cancellation of certain rights)
Withholding Tax
Where the arrangement is a cross-border loan, changes to the interest payments will also result in changes to the consequential withholding tax payable (if any). Consideration should also be given to the nature of any true-up payments or adjustments, and whether they may be in the nature of interest, and therefore subject to withholding tax.
Transfer Pricing
Where a financial arrangement is with an offshore related party, the transfer pricing implications of any amendments to the interest rate also need to be considered, to ensure the overall economics of the arrangement reflect arm’s length terms.
Provided the arrangement is simply amended to reflect the transition from an IBOR to a RFR, and the overall rate or economics do not change, the amendment should not be expected to result in a transfer pricing benefit. However, contemporaneous documentation should be maintained. Documentation should record and explain the amendment, as well as why the arrangement remains consistent with the arm’s length principles.
- David Early is a founding partner, CFO, and corporate tax specialist at Nuwaru, an accounting firm, in Darlinghurst, Australia.
Given the fact that Australian dollar based LIBOR stopped being reported some 9 years ago, it is curious that this is just now being discussed. One would think any Australian dollar floating rate loans issued recently would use BBSW as the base.