The London inter-bank offered rate (LIBOR), a globally accepted key benchmark interest rate for over 35 years , is being replaced by the reformed sterling overnight index average (SONIA) from 31 December 2021. In very broad terms, SONIA is a risk-free interest rate benchmark, calculated by reference to actual transactions, whereas LIBOR is a forward-looking rate that takes into account credit-risk. As such, SONIA and LIBOR are not readily comparable and the transition may, therefore, have potentially significant adverse tax implications for the unprepared and the unwary.
Implications for corporates
The focus of many corporate groups on the transition to SONIA will most likely be in relation to existing LIBOR-linked financing, hedging and leasing arrangements (eg loan notes, shareholder loans, intra-group arrangements and some other third party financing). There are a number of the key points which need to be addressed to ensure that not only are all potential tax liabilities on the transition to SONIA identified and, where possible, mitigated, but that accurate and timely management information is available. For example:
- What do current agreements, which reference LIBOR, provide for on transition to SONIA, and do they ensure there is a clear policy to apply when LIBOR is no longer published and an appropriate rate has to be calculated?
- If SONIA proves to be a lower rate than LIBOR, due to it being a risk-free rate, how does this fit into what return a lender should reasonably expect and how does this affect a groups’ transfer pricing and thin capitalisation policy and related documentation?
- Will the transition to SONIA trigger a derecognition event for statutory accounting purposes for an existing arrangement and the recognition of a new arrangement and, if so, could that trigger a taxable credit to the income statement?
- Will SONIA be aligned to the interest rate on the underlying instrument in relation to interest rate swaps ? If not, a material tax liability could arise and it will be essential to determine whether that liability is taxable.
In each instance, a detailed review of existing agreements which rely on LIBOR is recommended. Discussions need to take place with lenders and borrowers as appropriate, documentation should be prepared to evidence the analysis carried out, and updated agreements and supporting papers should be prepared as necessary. This analysis may also be of use in supporting management decision-making in relation to the change, as well as internal forecasting and discussions with a groups’ statutory auditor.
Implications for individuals
The end of LIBOR is not only significant for companies. There is a long tradition of using LIBOR as a benchmark for loan arrangements, especially between trusts and individuals.
Where a loan does not carry interest at a commercial rate, one party provides a benefit to the other. Normally this happens where a loan is interest-free, but it may also arise where abnormally low interest rates are charged, and the lender is treated as making an annual gift to the borrower equal to the interest foregone.
This has various tax consequences. If an individual makes a loan to a trust, they are treated as adding value to it each year. Not only is this potentially taxable in itself, but the tax treatment of the assets in the trust is also affected forever after. Equally, where a trust lends to a beneficiary, the ‘loan benefit’ can create an annual tax charge on the borrower.
To avoid these issues, many loans charge interest annually or on repayment, at a rate fixed by reference to LIBOR. Parties to such loans will need to change the terms – replacing LIBOR with the official HMRC loan interest rate, for example. Failure to make a suitable change could result in taxable benefits being generated. Any failure to recognise such a benefit may, in turn, lead to a failure to report, and such failures can result in penalties of up to 200 per cent of the tax due, as well as the permanent loss of the tax advantages loan arrangements currently provide.
In most cases, amending interest terms for a loan should be straightforward, but care will be required to make sure there are no unintended consequences. On the other hand, doing nothing to agreements based on LIBOR may have a serious negative tax impact that cannot be undone.