Much work has been done across the financial markets to prepare for the cessation of the publication of LIBOR at the end of 2021. With LIBOR thought to underpin more than $300tn of financial contracts across the world, it is hardly surprising that financial regulators and market participants have spent the last few years planning for LIBOR transition.
Nevertheless, national tax authorities (with the exception of the IRS) have been slow to respond to concerns raised by those who are currently in the process of amending their financial instruments and who require certainty as to the tax implications of the different mechanisms for addressing benchmark reform.
The publication by HMRC of its consultation document “Taxation impacts arising from the withdrawal of LIBOR” and accompanying draft guidance on 19 March 2020 is therefore a welcome step towards clarity in this area. In this blog we explore the changes currently being proposed.
Statutory references to LIBOR in tax legislation
The focus of the first part of HMRC’s consultation document is narrow, seeking to identify statutory references to LIBOR in UK tax legislation that need to be updated. The references that HMRC has already identified arise in a leasing context, where it is necessary to calculate the present value of lease payments using the interest rate implicit in the lease. The provisions in question use LIBOR as a fallback rate where the rate implicit in the lease cannot be determined. HMRC is seeking views on:
- how often these provisions are relied on;
- if there are any other statutory references that need to be updated; and
- what would be the appropriate rate to use in place of LIBOR in this context.
On this last point, HMRC is exploring three options: the overnight reference rate relevant for the currency of the lease (possibly compounded over a period of time to give a more stable read-out); a new term reference rate for the currency of the lease (a number are under development); or the relevant sovereign rate (although this could be tricky for instruments denominated in Euro). There are, of course, other options, such as the Bank of England base rate or, for Euro-denominated instruments, EURIBOR, which is not being discontinued.
UK tax issues arising from the withdrawal of LIBOR
The more substantial part of the consultation is an evidence-gathering exercise by HMRC to understand the full breadth of tax impacts that could arise from LIBOR transition. The gist of the consultation is that HMRC believes that beyond the legislative fixes described above, statutory intervention is unlikely to be necessary and that any remaining issues can be dealt with in guidance – although HMRC is looking to test that through this consultation.
In terms of issues that could arise prior to transition from LIBOR, HMRC has identified that the prospective withdrawal of LIBOR could impact hedge accounting, for instance, where a derivative can no longer be accounted for as a cash flow hedge on the basis that future cash flows will be uncertain. This could result in fair value movements being taken to profit and loss and becoming taxable.
In HMRC’s view, the changes that have already been made by the IASB and FRC to amend the hedge accounting rules for IAS and UK GAAP for accounting periods from 1 January 2020 should go a long way towards addressing this issue. These changes mean that when drawing up accounts, you can assume that the interest rate benchmark in an instrument will not be altered - and as a result, companies should still be able to apply hedge accounting.
Where hedge accounting does not apply, companies can make an election (under the Disregard Regulations) such that fair value movements are disregarded for tax purposes and instead brought into account (broadly) in line with the hedged risk. HMRC is seeking views on whether these two solutions are sufficient to deal with pre-transition issues or whether any other changes are required. (Making the Disregard Regulations election does require certain entry conditions to be met, for example.)
Issues on transition
Various mechanisms are being considered across the market to effect the transition away from LIBOR, including entering into replacement instruments which do not refer to LIBOR, or amending existing instruments either to replace the reference rate with a non-LIBOR rate or to vary the fallback provisions in the instrument such that, as and when LIBOR ceases to be published, a non-LIBOR rate will kick in.
Interaction with the accounting treatment: As the majority of financial instruments in question will, for tax purposes, fall within the accounting-based loan relationships or derivative contracts regimes, the tax impact of such changes will very much depend on the accounting treatment. For instance, if the amendment of a loan being carried at amortised cost is a “substantial modification”, this could lead to the instrument being derecognised for accounting purposes, with a new instrument recognised based on its fair value. This could result in gains or losses being recognised in profit and loss triggering a tax charge.
Similar issues could arise on transition in relation to hedge accounting as those described above in relation to pre-transition, i.e. the conditions for hedge accounting could cease to be met, creating additional volatility in profit and loss and correspondingly in the amounts brought into the charge to tax. Although the Disregard Regulations may in some cases allow fair value movements to be “disregarded” for tax purposes, these rules will not apply in all cases. That said, helpfully, HMRC’s draft guidance does clarify that where a reference to LIBOR in a hedging instrument is amended at a different time (and potentially using a different rate) to the hedged item, the Disregard Regulations can still apply even though there is no longer a perfect hedge or potentially increased hedge ineffectiveness, provided the intention to hedge remains.
To the extent that the Disregard Regulations do not apply, HMRC’s consultation document is pinning its hopes on further changes to accounting standards being able to fix any remaining issues. Close attention will therefore need to paid to the outcome of these ongoing accounting projects.
One-off payments: Given the challenges of finding a perfect replacement rate for LIBOR, there will inevitably be some who “win” and some who “lose” under whatever replacement rate is chosen for an instrument. As a result, where an instrument is amended, there may need to be a one-off additional payment to compensate the party that would otherwise lose out.
HMRC’s draft guidance clarifies that the tax treatment of such one-off payments will depend on the nature of the payment, and potentially on who is paying. For instance, if paid by the borrower under a loan to the lender, this will typically be characterised as an additional interest payment. However, where the payment flows the other way, this cannot be interest (as the borrower has made no advance to the lender) and should not require tax to be withheld, but rather this is likely to be regarded as an expense incurred to ensure the borrower continues to make interest payments.
New instruments? One of the most helpful aspects of the draft guidance published by HMRC is the confirmation that “where the parties agree to change the terms of the instrument for the purposes of responding to the withdrawal of LIBOR, HMRC would normally view this as a variation of the existing instrument.” This means that, generally speaking, LIBOR-transition related amendments should not be viewed as the rescission of the old contract and creation of a new contract, but as a variation of the existing contract.
This is particularly helpful for those seeking to rely on grandfathering provisions or existing tax clearances, elections or notifications. In particular, HMRC has confirmed that treaty directions allowing borrowers to pay interest gross should not be impacted by such changes, although there is no specific mention of whether one-off payments treated as interest would be covered by such existing directions.
It is worth noting, however, that HMRC will look to the intention of the parties, and in particular to how this is reflected in the legal documents, in order to determine whether the parties are amending an existing instrument or entering into a new instrument. This means that the manner of making the changes could potentially take on significance from a tax perspective. For instance, it may be logistically simpler to book a new transaction rather than amending an existing transaction; but even if from an economic perspective the changes would be identical either way, parties will need to keep in mind that the tax implications could be quite different depending on the method is chosen to effect the changes.
Other tax consequences?
- The draft guidance provides comfort that the amendment of a financial instrument as a result of LIBOR transition should not impact the availability of the loan capital exemption for stamp duty/SDRT purposes on the grounds of exceeding a reasonable rate of return, on the basis that this is tested when the right to interest is created and does not need to be revisited on an amendment to the reference rate. Similarly, whether the terms of an agreement are “arm’s length” for transfer pricing purposes is tested at the time the original provision is entered into and should not need to be reassessed on such an amendment.
- Likewise, when considering whether distributions treatment should apply to an instrument on the grounds of interest payments exceeding a commercial rate on the principal secured, HMRC do not see such LIBOR-transition amendments as constituting a material change that should alter the existing distributions analysis.
- For those instruments falling outside the accounting-based regimes discussed above, for instance, for instruments held by individuals, it may be necessary to consider whether an amendment to the terms of the instrument could be a disposal for capital gains purposes. Interestingly, HMRC’s previous indications that a chargeable gain or loss would not arise in such circumstances have not been included in the draft guidance. One take on this is that HMRC intends the guidance to be focused on implications for businesses and therefore that the omission is simply because HMRC considers the treatment of individuals to be out of scope. However, given that there are instances (even in the “business” context) where the chargeable gains analysis is relevant, it is hoped that HMRC can be convinced to provide some comfort on this.
The deadline for comments has been extended to 28 August 2020, with legislation to follow in Finance Bill 2020-21.
While the consultation and draft guidance do not provide all the answers, HMRC has taken an undeniably positive step in deciding to provide much-needed certainty in this area and it is hoped that this will encourage other tax authorities to follow suit.