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Moving beyond LIBOR: what tax and accounting professionals should know

December 22, 2020

by John Oliver

The financial industry is now well on the way to phasing out the London Interbank Offered Rate (LIBOR), the benchmark that is the key to contracts literally worth hundreds of trillions of dollars. Many firms have made good progress in preparing for this transition, but we still see gaps. (If you’re still in the early planning stages, I strongly encourage you to review our LIBOR publications and subscribe to our bimonthly newsletter.) Even for firms that actively worked on the shift, accounting and tax planning often doesn’t get enough attention. PwC’s Jen Hafemann hosted a webcast in December 2020 to discuss the emerging concerns and some potential responses.

Shifting timelines?

When will LIBOR end? For a long time, the industry was working toward a 12/31/2021 LIBOR phase-out. But LIBOR’s administrator, ICE Benchmark Administration (IBA), recently announced it would continue to publish some LIBOR rates — but not all LIBOR rates — for another 18 months. (See our LIBOR transition industry and market update for more details.) Some see this as an extension, but we think that’s the wrong way to view it. In actuality, it is clear that there is now a definitive end date to LIBOR. In addition, regulators seek to limit contracts written after 2021. Instead, they are looking for contracts tied to alternative reference rates (ARRs) like the Secured Overnight Financing Rate (SOFR) and the Sterling Overnight Interbank Average Rate (SONIA).

For market participants, this means several things:

  • Instruments affected by floating rate payments should include contractual language or fallbacks. You’ll want to consider how your firm’s US dollar LIBOR contracts incorporate fallbacks ahead of LIBOR’s cessation in the middle of 2023.

  • While the additional 18 months of published USD LIBOR rates offers some breathing room to use in remediating legacy LIBOR contracts, you are still expected to stop issuing new USD LIBOR contracts after 2021.

  • As LIBOR’s end date approaches, there could be far less liquidity in contracts that reference this benchmark. You’ll want to consider how this diminished liquidity could affect your firm, as well as potential adverse impacts on risk management and pricing.

Understanding your exposure

Many firms are clearly concerned with contract modification for hedges, as we saw from live polling during the webcast. The issues are considerable.

One basic step in moving beyond LIBOR is to understand your exposure. Most firms generally understand their direct exposure, including floating rate debt instruments and derivatives indexed to LIBOR. But you may not have as much insight into your indirect exposure through vendors or systems considerations.

Accounting and tax relief

The FASB and IRS have issued relief guidelines covering the LIBOR transition, and you’ll want to understand its impacts on your contract modifications. PwC’s Nick Milone pointed out that firms will want to consider if their contract modifications will be accounted for as a modification (continuation of the existing contract) or extinguishment. If you, or your counterparty, are looking to renegotiate terms, it may be more difficult to qualify for relief, and contracts that are considered to be extinguished could result in immediate impacts to the P&L.

  • PwC's Chad Clark mentioned that the application of the IRS’s relief for incorporating certain fallback language into legacy LIBOR contracts can be straightforward, and it generally constitutes a non-taxable event. This fall, the International Swaps and Derivatives Association, or ISDA, published its official fallback protocol covering derivative trades that reference LIBOR and other Interbank Borrowing Rate (IBOR) benchmarks. The Alternative Reference Rates Committee (ARRC) proposed its own fallbacks for other instruments. But the relief guidance is still pretty narrow, and we encourage firms to exercise caution when amending contracts for certain financial products, such as bilateral or syndicated loans, since certain aspects of fallback language that were not recommended by the ISDA or ARRC may not fit into the guidelines. 

  • Some modifications may be significant enough that you might trigger a testing requirement under traditional rules that could result in a taxable event. You’ll want to carefully review the guidance around what remediation of legacy LIBOR contracts might qualify for relief and what requires additional testing. One big difference between accounting and tax relief is a fair market requirement under the tax rules. Generally, tax relief is only applicable if the fair market value (FMV) of the instrument remains substantially the same before and after the modification occurs. You should be prepared to provide quantitative analysis on a contract-by-contract basis to demonstrate that the FMV requirement has been met. You’ll want to be sure your processes and/or technology can support these demands, if needed to avoid unintentional tax consequences.

PwC’s David Challen pointed out that hedge accounting involves another significant piece of the relief. Some issues to watch out for:

  • Companies impacted by the change to discounting for centrally cleared interest rate derivatives may need to adopt the FASB relief for a hedge to continue;

  • For long-dated LIBOR hedges that continue beyond 2023, you’ll want to apply FASB relief to continue hedge accounting.

Hedging tax implications

To get your arms around the scope of your LIBOR transition, PwC’s Brian Ciszczon encourages companies to consider scale, because “derivatives make up the lion's share of instruments for LIBOR remediation.” But the rules can be complicated, and the type of derivative being used, or the nature of the counterparty, may determine if the strategy will impose a taxable gain or loss.

Generally speaking, derivatives were treated differently for tax and GAAP before LIBOR reform, and that will continue to be true throughout the transition. For example, consider an investor that enters into a multi-year total return swap with a LIBOR leg. If that investor remediates the contract in a way that doesn’t qualify for relief, they could see a massive (and unexpected) built-in gain or loss. That’s why knowing your counterparty, and their level of exposure, is so important.

Getting to work

So, how can accounting and tax departments get ahead of this shift? Here are some “leading practices” to consider:

  • Review your condition. Your company will need the ability to quantify exposure and establish a standardized computational method of evaluating which amendments qualify for relief and which don’t. You’ll want to be sure your systems are appropriately upgraded so you can conduct modification and fair market testing approaches on a large scale. One helpful step: use available tools to organize your loan data for the task. This can accelerate this process and improve efficiencies.

  • Reevaluate your firm's timeline. While the end date may give some more time, the time period between December 31, 2021 and June 30, 2023 presents new risks as new LIBOR production ceases and SOFR products take hold. David Challen reminds us FASB accounting relief sunsets at the end of 2022. Even if this date moves, don't waste the extra time to get ahead. Other obstacles may arise, including reduced liquidity and increased hedging costs.

  • Reconfigure your operating platform to include accounting, tax and front office. Even small steps to upgrade your technology could ease your LIBOR transition in unexpected areas. There are a variety of things to track: preferred stock with LIBOR-linked dividends, transfer pricing contracts requiring reevaluation due to LIBOR, LIBOR exposure in infrastructure, etc. You’ll want to monitor all of it so you can determine which remediation decisions will be most effective.

  • Report year-end disclosures. The clock is running out, and you’ll need to disclose your LIBOR exposures as well as your plan with respect to FASB optional accounting relief for contracts and hedging.

Contact us

John Oliver

Partner, PwC US