South African IBOR Transition - A Transfer Pricing Perspective

This is our first article in a series of IBOR transition articles that will provide you with insights to Rethink your organisation within this context. This first article will consider the transfer pricing and tax perspective of the IBOR transaction in South Africa.

In the major financial markets, reference rates, such as the London Interbank Offered Rate (LIBOR) and Euro Interbank Offered Rate (EURIBOR), are widely used as benchmarks for a large volume and broad range of financial products and contracts. Thus, many financial arrangements such as loans, bonds and derivatives, are pegged to a reference point for variable interest rates such as LIBOR. These reference rates are called interbank offered rates (IBOR) and may differ from country to country.

In the case of South Africa (SA), the Johannesburg Interbank Average Rate (JIBAR) is usually used as a benchmark when dealing with short-term interest rates in the SA economy. JIBAR, similar to IBOR, is determined by considering the average of the borrowing and lending rates indicated by a number of local and international banks. Considering that JIBAR and LIBOR are similar, they are interbank offered rates, we have used LIBOR as the main point of discussion for purposes of this article as LIBOR is mostly referenced around the world.

By the end of December 2021, rates such as LIBOR will be retired and replaced with an alternative reference system. The phase-out of LIBOR has been heralded since 2012 when the combined forces of a high-profile scandal and the 2009 recession exposed the vulnerabilities and weaknesses of LIBOR and the need to find an alternative. Given the scope of the impact of the LIBOR phase-out, affected businesses should be taking steps now to plan for the transition. It should be noted that the South African Reserve Bank (SARB) also supports this move as there are shortcomings with the JIBAR and as such, will also look to implement a new rate. The SARB has indicated that as the administrator of JIBAR, it will cease at some future point.

The new system will be a variety of alternative risk-free and near-risk-free rates (RFRs), mostly administered by central banks. LIBOR’s replacements in the five major currencies chosen are: SOFR (USD), SONIA (GBP), €STR (EUR), SARON (CHF) and TONA (JPY). These will be used for all types of variable interest rate contractual arrangements and financial instruments. The proposed replacement for JIBAR will be South African Rand Overnight Index Average (ZARONIA).

SA Transfer Pricing Considerations

The adjustment to a world without LIBOR (and other IBORs) will undoubtedly have an impact to most current financial arrangements in place. Businesses need to adjust accordingly and one of these changes would be the potential effect on the arms-length nature of their financial arrangements with related entities.

The scope of this could be significant given the universal nature of variable rates associated with financial arrangements such as loans and other financial contracts between related entities. Examples of these include: financial contracts entered into directly between a parent and subsidiary, a centralised cash management structure such as a group treasury or even back-to-back lending arrangements.

Replacing LIBOR (or other IBORs) on these current arrangement may require companies to evaluate the current LIBOR-based variable interest rate pricing against an alternative base rate applying an arms-length spread so that neither party to the transaction is disadvantaged. Any new intercompany agreements should avoid the risk of going through this change by already setting the terms to an appropriate RFR and an arm’s length spread.

It is important that any change, for example, from LIBOR to SONIA requires both parties to end up similar to how they were before the LIBOR change. There are no instructions for how to calculate this arm’s-length spread, but such an analysis will need to follow the principles set forth under existing transfer pricing rules.

Businesses will also need to ensure that the changes are supported by contractual clauses in their new and existing agreements. To the extent that a LIBOR is referenced in such agreements, the appropriate fall-back language (recommended by the Federal Reserve’s Alternative Reference Rates Committee or ARRC) should be included. This is also supported by the SARB where contracts reference JIBAR.

Unfortunately, SARS has not released any guidance on this yet from a transfer pricing perspective.

Tax Effect of Changing Agreements

Taxpayers may have various ways in which they can amend or change their agreements in order to facilitate the IBOR transition. They might decide to settle the current agreement and then draft a new agreement, alternatively they could keep the current agreement in place and merely provide an addendum.

In terms of the Income Tax Act No. 58 of 1962 (ITA), section 24J determines how interest must be calculated. Thus, it follows that where taxpayers change/amend or enter into a new financial arrangement during the tax year, consideration must be given to section 24J to ensure the correct amount of interest is incurred or accrued.

In addition, taxpayers who are considered as lenders in the financial arrangement will need to determine if a disposal event has taken place under the Eighth schedule. Paragraph 11 of the Eighth schedule may determine that the agreement has been subject to a cancelation, termination or variation of the agreement and thus a disposal event has taken place. Alternatively paragraph 11 may also indicate that a non-disposal event has occurred and thus no tax effect.

The tax effect of changing financial arrangements will ultimately first depend on how taxpayers choose to transition to IBOR.

The Key to Success

The recommended first step is for affected companies to identify current intercompany agreements containing any LIBOR (or other IBOR) references and undertake the processes to modify those agreements. For new agreements, it is suggested to already incorporate the new RFRs or apply a fixed rate but keeping in mind the transfer pricing principles and applying these accordingly.

Thinking about potentially damaging legal implications now should eliminate them later. Once the impacted agreements are identified, companies should develop a plan to adjust the pricing of their affected arrangements to be ready once LIBOR is discontinued. With less than a year remaining before LIBOR is replaced, being proactive now will help to mitigate or prevent any future business disruptions.

Our next articles within the IBOR transition will consider this further from a legal, technical accounting and valuations perspective. 

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