Guidance

Guidance on the taxation implications for businesses from the withdrawal of LIBOR and other benchmark rate reform

Updated 12 January 2021

London Inter-bank Offered Rate (LIBOR) is a set of interest rate benchmarks based on the rates at which banks are willing to borrow wholesale unsecured funds. It is used in a large number of loans, derivatives and other financial instruments.

Consistent with a report by the Financial Stability Board in July 2014, attempts have been made to try to anchor LIBOR submissions and rates to actual transactions to ensure the sustainability of the rate.

While significant improvements have been made to the benchmark since then, the underlying market that LIBOR seeks to measure, the market for unsecured wholesale term lending to banks, is no longer sufficiently active.

In a speech in 2017 the Financial Conduct Authority (FCA) indicated publicly that they do not intend to use their powers to compel panel banks to contribute to LIBOR after the end of 2021.

Panel banks have voluntarily agreed to continue providing submissions to LIBOR until then, but its publication cannot be guaranteed beyond this date.

On 23 June 2020, the Chancellor made a written ministerial statement indicating that the government will ensure the FCA’s powers are sufficient to manage an orderly transition from LIBOR.

This will include extending the circumstances in which the FCA may require an administrator to change the methods of a critical benchmark and providing them the ability to specify limited continued use of LIBOR in legacy contracts.

It remains the case that businesses cannot rely on the benchmark’s continued publication and firms will therefore need to continue to migrate away from LIBOR as a reference in their financial contracts.

In advance of this, it is likely that banks will contact affected parties to discuss their plans to either:

• change the terms of any existing financial instruments that use LIBOR
• replace them with new instruments that do not use LIBOR

This paper explains HMRC’s view on the tax implications for businesses of changes to financial instruments driven by benchmark reform. It is of a general nature and is based on the law as at the date of publication.

Although this guidance refers specifically to LIBOR, other benchmark rates are also being withdrawn or otherwise reformed. For example:

• Euro Overnight Index Average (EONIA)
• US Effective Federal Funds Rate
• Euro Interbank Offered Rate (EURIBOR)

Businesses may therefore also be looking to restructure financial instruments which contain references to these other reference rates. The guidance below applies equally in those situations.

This guidance applies to changes to financial instruments where they make amendments to:

• replace the benchmark rate they refer to
• introduce or amend fallback provisions
• make incidental amendments that are consequential to replacing the benchmark rate

The fallback provisions this applies to determine how the contract should operate if the designated benchmark rate is permanently discontinued, is considered unrepresentative or otherwise cannot be used.

An example of incidental amendments that are consequential to replacing the benchmark rate is making amendments to the applicable interest margin to better equate the replacement rate with LIBOR or making additional payments to broadly preserve the parties’ economic position.

Contracts may be amended due to:

• direct negotiation
• changes in a bank’s standard terms and conditions
• a clearing house’s rulebook
• through the parties adopting industry standard language

Examples of industry standard language are:

• for derivatives, the International Swaps and Derivatives Association’s Benchmark Supplement, and IBOR Fallbacks Supplement, to the 2006 International Swaps and Derivatives Association Definitions and the 2020 IBOR Fallbacks Protocol (published on the 23 October 2020 to facilitate amendments to legacy contracts)
• for loans, the Loan Market Association template terms

It is thought that in the majority of cases the changes to the instrument made for the purpose of responding to benchmark reform will be relatively minor and that the economics of the transaction between the parties will be broadly maintained.

This is expected to be the case where a business does no more than change their contracts in a demonstrably market standard way, for example by doing any of the following:

• adopting the language in the International Swaps and Derivatives Association or Loan Market Association documents above (or equivalent documents of other similar organisations)
• replacing the existing reference rate and associated conventions with the corresponding alternative reference rate and conventions used in the International Swaps and Derivatives Association or Loan Market Association documents (or equivalent documents of other similar organisations)
• incorporating any changes recommended by the Sterling Risk-Free Reference Rates Working Group or equivalent body outside the UK

We would expect the guidance to apply to such transactions.

References in this guidance to ‘financial instruments’ should include leasing and other contracts, as well as loans and derivatives, unless the context implies otherwise.

Businesses will need to consider their own circumstances carefully and make sure that any specific statutory provisions that are relevant are applied as appropriate. In cases where there is, or may have been, avoidance of tax, the application of the law (including anti-avoidance provisions) may result in a different tax treatment.

If you are not sure of the steps you need to take in relation to tax, then you should discuss this with your Customer Compliance Manager or contact HMRC if you do not have one.

It is the responsibility of the business or individual to prepare accounts in accordance with generally accepted accounting practice and submit a Corporation Tax return or Income Tax return as appropriate.

HMRC has also produced similar guidance for individuals to refer to.

What might replace LIBOR

There are a number of existing interest rate benchmarks which could replace LIBOR in a financial instrument.

The Sterling Risk Free Rate Working Group has recommended the Sterling Overnight Index Average as its preferred risk-free rate to replace sterling LIBOR.

It is calculated by looking at the rate paid by banks on overnight funds and therefore needs to be aggregated in some way to be used over a term interest period. Similar benchmarks have been recommended for different LIBOR currencies, for example Secured Overnight Financing Rate for the US dollar and Swiss Average Rate Overnight for the Swiss Franc.

Restructuring a financial instrument: amounts recognised in profit or loss

If the terms of a financial instrument are amended, the way this is treated in the accounts could affect the tax treatment.

There are specific provisions in the Corporation Tax rules for companies that cover the taxation of financial instruments. These are:

• loan relationships (Part 5 of the Corporation Tax Act 2009)
• derivative contracts (Part 7 of the Corporation Tax Act 2009)

You can find more information in the Corporate Finance Manual about loan relationships and derivative contracts.

The general rule is that the amounts to be brought into account for tax under these provisions are the amounts that are recognised in determining a company’s profit or loss for the period.

There can be exceptions to this general rule, where the tax treatment deviates from the accounting treatment in specific circumstances. For example, where the parties to a lending transaction are connected companies, the loan is treated for tax purposes as if it were held on an amortised cost basis of accounting.

Impairments of connected company debt are not brought into account for tax. In addition, where connected company debt is amended or redeemed, any debit arising in the creditor company can also, in certain circumstances, be disallowed.

Different rules apply for businesses that are subject to Income Tax. However, where a financial instrument is taken out for the purposes of a trade or property business, the tax treatment will generally follow the accounting treatment in a similar way.

It should be noted that there are certain differences. For example, under the Income Tax rules payments will not be deductible if they are capital in nature, (see section 33 of the Income Tax (Trading and Other Income) Act 2005).

Further advice on determining whether an amount is capital or revenue can be found in the Business Income Manual at BIM35000.

As a result, under both Corporation Tax and Income Tax rules, where the terms of a loan or derivative are amended to use a new interest rate, the tax treatment for the business will typically depend, in part, on the accounting treatment.

Where amounts are recognised in the income statement, these will typically be brought into account for tax purposes, although as noted there can be exceptions to this treatment. Where the amendment of a loan or derivative does not change the amounts recognised in the income statement there should not generally be any impact on Income Tax or Corporation Tax for the business.

On 27 August 2020, the International Accounting Standards Board finalised its response to the ongoing reform of LIBOR and other interest rate benchmarks to address financial reporting issues by issuing a package of amendments to the International Financial Reporting Standards.

The Financial Reporting Council had on 29 May 2020 published proposals which would make similar changes to UK Financial Reporting Standards. The consultation on those proposed changes closed on 30 September 2020.

In particular, there are 2 easements in cases of the modification of a financial asset, financial liability or lease liability which is as a direct consequence of benchmark reform and where the new basis for determining the contractual cashflows is economically equivalent to the previous basis.

Firstly, as a practical expedient, an entity can update the effective interest rate (EIR) to reflect the change in contractual cashflows due to interest rate benchmark reform, instead of derecognising or adjusting carrying amounts of financial assets, financial liabilities, and lease liabilities.

Secondly, the entity will not be required to discontinue hedge accounting when amending hedging documentation to reflect such modifications as long as the hedge meets the other hedging criteria.

Amending or creating a financial instrument

Depending on the circumstances and terms of the legal documents involved, the amendment of a financial instrument will form either:

• the continuation of an existing financial instrument (variation of the original)
• the creation of a new financial instrument (rescission of the original)

The intention of the parties, and how this is reflected in the legal documents, will be significant factors in determining whether the changes legally constitute an amendment to an existing financial instrument, or the redemption and replacement of an existing financial instrument with a new financial instrument.

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. The amended contract should be regarded as the same contract and entered into at the same time as the original one.

This would apply, for example, where the parties agree to replace LIBOR for one of the new reference rates or with a fixed interest rate. It does not matter if the spread on the instrument needs to be amended slightly, or if additional payments are made between the parties, provided the economics of the transaction remain broadly the same.

As an operational matter, business may decide to record or book amendments to legacy contracts on their internal systems by cancelling an existing systems entry and booking a new entry on the system but with the same parameters as the original transaction (besides those relating directly to implementation of benchmark reform).

How an amendment is logged on an internal system does not determine the nature of the agreement between the parties.

What matters is the position agreed between the parties to the contract, and whether this represents an amendment to an existing contract or a rescission of an existing contract and the creation of a new contract.

Business may wish to keep contemporary evidence to demonstrate the true nature of the agreement between the parties, such as through notes added to the system entries.

There are a number of taxation provisions where the above analysis, that is, considering whether there has been a rescission or a variation, will be relevant. A number of these examples set out below in more detail.

These are simply examples, and the analysis should also apply more generally to a wide range of additional provisions where it is necessary to determine whether a financial instrument that is amended as a result of the benchmark reform constitutes a variation or rescission of the original financial instrument.

Where fall-back provisions come into operation according to the existing terms of the original agreement, this should not be regarded as an amendment to the contract and therefore in the absence of any other changes it will not be necessary to consider whether a new contract has been created.

Taxation provisions

The Disregard Regulations

The Disregard Regulations (S.I. 2004/3256) allow a company to disregard certain fair value movements that arise on a derivative contract that is hedging particular risks, provided a valid election has been made and certain conditions are met.

The Disregard Regulations apply where a hedging instrument is intended to act as a hedge of a hedged item. It is possible that references to LIBOR in the hedging instrument will be amended at a different time to references to LIBOR in the hedged item and they could even be replaced with different rates. Despite this, the Disregard Regulations can still apply provided the intention to hedge remains.

It does not matter that there is no longer a perfect hedge going forwards or that there is an increased level of hedge ineffectiveness.

Grandfathering

In some circumstances legislation provides particular treatment for instruments entered into before a specific date. This means a historic tax treatment still applies to an existing instrument even though the tax treatment changes for new instruments entered into after a specific date.

This is known as grandfathering. Where a financial instrument benefits from a grandfathered treatment, HMRC would normally expect this treatment to continue where amendments are made for the purpose of responding to benchmark reform as outlined above.

There are a few grandfathering provisions where this could apply.

For example:

• the qualifying old loan relationship rules that only apply to loans entered into on or before 12 May 2016
• changes made to the loan relationship and derivative contract regimes by Finance (No.2) Act 2015
• certain leasing provisions

Making an additional payment

One party might need to make a one-off payment, or series of payments, to the counterparty to compensate for the changes in terms when the financial instrument is amended to respond to benchmark form. Who receives this payment depends on how the expected cash flows under LIBOR compare with the expected cash flows under the new reference rate.

For example, if the legacy instrument was a loan and the expected cash flows representing payments of interest are lower under the new reference rate, you would expect the borrower to make a payment to the lender for the shortfall.

It is necessary to consider the nature of this payment and this will depend on the nature of the legacy contract, and which party is making the payment.

For example, if the legacy contract is a loan, and the borrower makes a payment to the lender, in respect of a change to the way interest is calculated, this would normally be treated as interest because it will meet the hallmarks of interest.

Find more information by reading Corporate Finance Manual CFM33030.

In particular, the amount represents compensation for the use of the money advanced by the lender. The borrower may have to deduct Income Tax on the payments in a similar way to the ordinary payments of interest on the instrument.

Any exemptions or reliefs applying to the interest payments under the instrument, for example treaty clearances, would be expected to apply equally to the additional payment. Clearances are covered below in further detail.

However, if a lender has to make a payment to the borrower, this cannot be interest because the lender does not have the use of any money and so cannot be compensation for the use of money.

This payment is likely to be an expense incurred by the lender to make sure the borrower continues to make interest payments considering that these will now have increased.

It is unlikely the lender will need to deduct Income Tax on any such payment because such an expense should not fall within Part 15 of the Income Tax Act 2007.

In cases where the additional payment relates to a derivative contract by a company, such a payment would be exempt from the requirement to deduct Income Tax under section 980 of Income Tax Act 2007.

Where the payment is recognised in the income statement, that amount would normally be brought into account for tax purposes. For companies, this is likely to be under either the loan relationship or derivative contract regimes, depending on the type of financial instrument. For other businesses, this is likely to be under the rules for trades or property businesses.

If the legacy contract is a lease, and an additional payment is made to compensate for changes to the manner in which rental payments are calculated, the additional payment would normally be treated as either:

• a rental payment if made by the lessee
• a rental rebate, if made by the lessor

Any exemptions or reliefs applying to the interest payments under the instrument (such as treaty clearances) would be expected to apply equally to the additional payment. Clearances are covered below in further detail.

The payment will not normally fall within Part 15 of the Income Tax Act 2007, and the payer will not be required to apply withholding tax.

HMRC does not envisage any unusual VAT consequences arising from the discontinuation of the use of LIBOR.

There should be no reason to reconsider the liability of the original supply made as only the consideration is being adjusted.

Any adjustments to the consideration for the supply made, whether an increase in consideration or a reduction, should be accounted for as normal.

For example, where the original supply was exempt, as would be the case for legacy contacts which are loans or derivatives, additional payments on LIBOR transition will not be subject to VAT. Any amendments to property leases between landlord and tenant would likewise follow the normal rules for VAT.

Hybrid Mismatch

It is possible that cross-border payments made in respect of the withdrawal of LIBOR, or the reform of other reference rates, between related parties could fall within the scope of the hybrid mismatch rules, as there may be a deduction or non-inclusion mismatch within the normal permitted period of the payee.

This could be the case where the payments are treated differently by the jurisdiction in which the parties to the transaction are based.

Where the payee includes the payment in a later period, companies may wish to consider making a claim where required, under the relevant provisions of Part 6A of the Taxation International and Other Provisions Act 2010, for the permitted period to be a later period of the payee where it is just and reasonable for the amount of ordinary income to arise for that taxable period rather than an earlier period.

This is likely to be appropriate where it is apparent the difference in treatment is merely timing and the change has arisen as a result of a commercial transaction, impacted by the withdrawal of LIBOR or reform of other reference rates.

The claim should be made in the tax computations of the company, when submitted as part of the tax return of the company for the relevant period. Non-statutory clearances on this point may be made to mailboxhybrids@hmrc.gov.uk.

Double Taxation Treaty Passport Scheme

If a UK company borrows from an overseas lender it should deduct amounts representing Income Tax at the basic rate when it makes interest payments to the lender.

HMRC operate a number of schemes which allow payments to be made gross including the Treaty Passport Scheme and the Syndicated Loans Scheme.

If a loan falls under either of these schemes, and there is a material change to the terms or ownership of it, the lender or syndicate manager should notify HMRC to make sure that payments can continue to be made gross.

Sections DTTP30410 and DTTP30420 of the Double Taxation Treaty Passport Scheme explain what constitutes a material change.

HMRC would normally expect that changes to an agreement for the purposes of responding to benchmark reform would not amount to a material change and there should therefore be no need to contact HMRC.

Such changes should not impact a treaty direction which is already in place and there should therefore be no need to make a fresh treaty clearance.

Further guidance on treaty clearances more generally can be found in the ‘clearances’ section below.

Reporting requirements

Businesses must comply with certain reporting requirements such as the EU Mandatory Reporting rules (DAC6) and the International Movement of Capital regulations.

Where such requirements depend on a new financial instrument being created, HMRC would expect that amendments made for the purpose of responding to benchmark reform as outlined above, should not create a new financial instrument.

There should therefore be no requirement to make a report under such provisions and in such circumstances.

In addition, the Bank, Building Society Interest and Other Interest returns both mandate certain reporting requirements on banks, building societies and other financial institutions.

These reporting requirements need to be considered where additional payments are made.

In cases where the borrower makes a payment to the lender in respect of a change to the way interest is calculated, the payment would normally be treated as interest.

Where the original interest payments under the loan are reportable, we would expect that such additional payments would also be included within the Bank, Building Society Interest or Other Interest returns.

Where additional payments are made in the opposite direction from lender to borrower, these payments cannot represent interest. Cashflows that are not easily identifiable as interest do not require inclusion on a Bank, Building Society Interest or Other Interest return.

Stamp Duty and Stamp Duty Reserve Tax

A transfer of loan capital is exempt from Stamp Duty and Stamp Duty Reserve Tax if the interest rate on the capital does not exceed a reasonable rate of return, provided the other conditions of the loan capital exemption are met.

HMRC does not expect that changes to a financial instrument for the purposes of responding to benchmark reform as outlined above should by themselves have any impact on this exemption because this condition is tested at the point that the right to interest is created.

It would not normally be necessary to revisit this test on the amendment to the reference rate.

Find more information in the Stamp Taxes on Shares Manual (STSM41060).

Company distributions

Where a company makes payments of interest that exceed a commercial rate on the principal secured, this may be treated as a distribution by paragraph E of section 1000(1), of the Corporation Tax Act 2010 with the result that no tax relief would be available for this amount.

A material change in the terms of a security can cause the analysis of whether a payment in respect of that security comes within paragraph E to change.

HMRC would expect that amendments made for the purpose of responding to benchmark reform as outlined above will not themselves constitute a material change.

Equity holder status

In order to qualify for group relief, certain tests must be met regarding the degree of connection between entities.

These include conditions regarding entitlements to assets and profits, which in turn require an entities’ equity holders to be identified.

There are circumstances where a lender of a loan to an entity could constitute one of its equity holders. This may be the case if a loan carries a right to interest which exceeds a reasonable commercial return on the new consideration lent - as such loan would not constitute a normal commercial loan within the meaning of section 162, Corporation Tax Act 2010.

Find more information in the Company Taxation Manual.

HMRC does not expect that changes to a financial instrument, for the purposes of responding to benchmark reform, should by themselves have any impact on the question of whether a loan carries more than a reasonable commercial return for this purpose.

Transfer pricing

In certain cases, if a company enters into financial instruments with an associated person, the UK transfer pricing rules require the taxable profits to be calculated on the assumption that that financial instrument was on arm’s length terms.

In many cases, the arm’s length price of financial instruments may have been specified by reference to LIBOR.

For example, the arm’s length interest rate charged on intra-group loans may have been based on LIBOR plus a margin.

There may also have been references to LIBOR used to decide on the arm’s length price of non-financial contracts.

HMRC will normally accept that parties to a contract that references LIBOR would, acting at arm’s length, agree to make changes to the contract to respond to the reform of the benchmark.

It would not normally be necessary to reassess whether the terms of the original agreement are arm’s length as this is tested at the point the provision was originally entered into.

Groups should:

• document their transfer pricing methods to make sure the amounts reflected in their tax computations are supported by following Organisation for Economic Co-operation and Development guidance
• update their documentation to reflect the withdrawal of LIBOR from the end of 2021
• make sure that any amendments to financial instruments between associated persons are undertaken on an arm’s length basis

Where an amendment takes place in line with market standard terms, for example:

• under International Swaps and Derivatives Association documents
• under Loan Market Association documents
• under equivalent documents of other similar organisations
• on terms which reflect the alternative reference rate and conventions used in the above-mentioned documents
• pursuant to recommendations of the Sterling Risk-Free Reference Rates Working Group or equivalent bodies outside the UK

HMRC would normally expect the arm’s length nature of the transaction to be preserved.

Clearances

In some circumstances businesses can request a clearance from HMRC on the tax treatment of a particular arrangement.

Existing clearances could involve financial instruments that need to be amended to replace references to LIBOR and to respond to the reform of benchmark rates.

The business may still rely on the certainty given by the clearance provided:

• the amendment to the financial instrument does not affect the broad economics of the transaction
• there is nothing significant in the tax analysis of the transaction that would be affected by the amendments

If the changes went wider than this, and had a material impact on the transaction which is subject to the clearance, HMRC would no longer be bound by the clearance.

It would be the business’ responsibility to make sure that the amendment is treated correctly.

A company can also apply to HMRC for an Advance Thin Capitalisation Agreement if they are concerned the transfer pricing rules might be used on a proposed funding arrangement, for example, where an intra-group loan is entered into.

There is more information HMRC’s International taxation manual (INTM512000).

Where an Advance Thin Capitalisation Agreement has already been given for a funding arrangement based on LIBOR, the company will need to consider the amended terms and will need to be satisfied that the amendments to the loan agreement are undertaken on arm’s length terms.

In this case, the Advance Thin Capitalisation Agreement can remain in place and the company will not need to submit a new application detailing the new terms.

The Advance Thin Capitalisation Agreement will no longer apply if there are any other amendments to the funding arrangement.