Withdrawal of LIBOR: tax guidance

The Government has published updated guidance on the tax implications of the withdrawal of LIBOR following a consultation over the summer. The guidance covers a number of scenarios and clarifies the tax treatment of the need to amend or replace existing financial instruments which contain references to LIBOR or similar benchmark rates which are due to be withdrawn from the end of 2021.

It should be noted that the guidance is, however, limited to cases where the changes made to contracts are relatively minor and the overall economics of the relevant transaction are maintained.

Background

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. However, as a result of changes in the markets, it became clear that LIBOR can no longer be relied upon longer term and will be withdrawn from the end of 2021.

As a result of the withdrawal of LIBOR, businesses will no longer be able to rely on the benchmark's continued publication and will therefore need to move away from LIBOR as a reference in their financial contracts. In many cases, this may result in either: changes the terms of any existing financial instruments that use LIBOR; or replacement of  them with new instruments that do not use LIBOR.  

In March 2020, the government published draft guidance along with a consultation "Consultation on the taxation impacts arising from the withdrawal of LIBOR". The government has now published a response document to the consultation along with updated guidance. The updated guidance explains HMRC's view on the tax implications for businesses of changes to financial instruments driven by benchmark reform. It has now been updated following the responses to the spring consultation.

Although the guidance refers specifically to LIBOR, other benchmark rates are also being withdrawn or otherwise reformed as a result of international regulatory convergence.  As a result, businesses will be seeking to remediate agreements by replacing LIBOR with an alternative risk free rate -- likely to be SONIA in the case of loans denominated in sterling and other risk free rates in the case of loans denominated other currencies.  Businesses also looking to restructure financial instruments which contain references to these other reference rates may also rely on the guidance.

Guidance

The guidance applies to changes to financial instruments made to replace the benchmark rate they refer to, introduce or amend fallback provisions or make incidental amendments that are consequential to replacing the benchmark rate. The guidance applies whether the changes are made by direct negotiation or through changes to a bank's standard terms or standard industry terms.

The guidance is predicated on the fact 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. Respondents had suggested that this requirement might be relaxed by adopting a more purposive test ie that the guidance should apply provided that the purposes of the changes was to respond to the withdrawal of LIBOR. That request has however been rejected and taxpayers will need to make a judgement as to whether the economics of the transaction are broadly the same for the guidance to apply.

The guidance notes that, 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); or the creation of a new financial instrument (rescission of the original).

The guidance confirms 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. The amended contract should be regarded as the same contract and entered into at the same time as the original one. This would be the case where, for example, the parties agree to replace LIBOR with a 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 mostly the same.

HMRC accept that even where, as an operational matter, a 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, this will not affect the true nature of the transaction, which depends on the nature of the actual agreement between the parties.

The guidance goes on to consider a number of taxation implications where the question whether there has been a rescission or a variation will be relevant.

Additional payments

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 reform. For example, if the instrument was a loan and the expected cash flows representing payments of interest are lower under the new reference rate, the borrower might be required to make a payment to the lender for the shortfall. The nature of any such payment will depend on the nature of the contract and the party making the payment and this may impact on the need to withhold tax on any such payment.

For example, if the 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 ie compensation for the use of the money advanced by the lender. HMRC confirm that 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.

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. HMRC confirm that in such circumstances it is unlikely the lender would 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 under either the loan relationship or derivative contract regimes, depending on the type of financial instrument, in the case of companies.

The guidance also confirms that any exemptions or reliefs applying to the interest payments under the instrument (e.g. treaty clearances) would be expected to apply equally to the additional payment.

If the contract is a lease, and an additional payment is made to compensate for changes to the manner in which rental payments are calculated, then the additional payment would normally be treated as either: a rental payment if made by the lessee; or a rental rebate, if made by the lessor.

Treaty clearances and QPP certificates

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, unless the lender is entitled to exemption from such UK withholding tax, such as treaty relief or the qualifying private placement (QPP) exemption. In the case of treaty relief, the exemption from UK withholding tax does not apply unless and until a treaty clearance is issued by HMRC, which in practice is often obtained using the Double Tax Treaty Passport Scheme to simply the process. In the case of the QPP exemption, instead of requiring an HMRC clearance, the lender provides a QPP certificate to self-certify it meets the relevant conditions.

If a loan benefits from a treaty clearance and there is a material change to the terms or ownership of it, the lender or syndicate manager may need either tonotify HMRC of the change or to refresh the treaty clearance for the amended loan to enable interest to continue to be exempt from UK withholding tax, depending upon the circumstances. However, the guidance confirms that HMRC would normally expect that changes to an loan 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 clearance which is already in place and there should therefore be no need to make a fresh treaty clearance application or otherwise notify HMRC of the change.

Where the need to replace a reference rate is taken as an opportunity to update the commercial terms of a loan more broadly, consideration will need to be given to whether any additional changes are "material" for relevant purposes and would trigger a requirement to apply for a new treaty clearance.  In such circumstances, depending on the timing and frequency of interest payment dates it may be necessary to make arrangements in the loan documentation for interest to be accrued (and not paid) until the new treaty clearance is in place. However, HMRC's view of what constitutes a "material" change is helpfully quite narrow, and focuses principally on the name, business address and beneficial ownership of the parties and on the size of the loan. So even many amendments to a loan agreement which may be commercially significant do not amount to a "material" change for the purposes of continuity of the existing treaty clearance.

Similarly, if a loan which uses the QPP exemption from UK withholding tax is amended to reflect changes to the benchmark, this generally would not be expected to impact the validity of the existing QPP certificate. Hence the QPP exemption would generally continue to apply automatically to the amended loan, without any need for re-issuance of the QPP certificate.

VAT

HMRC also confirm that they do 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 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.

Stamp duties

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. The guidance confirms that 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 this exemption because this condition is tested at the point that the right to interest is created and it would not normally be necessary to revisit this test on the amendment to the reference rate.

Transfer pricing

Where a company enters into financial instruments with an associated person, the UK transfer pricing rules may 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.

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.

In the guidance, HMRC suggest that groups should:

• document their transfer pricing methods to make sure the amounts reflected in their tax computations are supported by following OECD 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.

In addition, where an amendment takes place in line with market standard terms (such as under ISDA or LMA standard terms), then HMRC confirm that they would normally expect the arm's length nature of the transaction to be preserved.

Clearances

Where an existing clearance involves a financial instrument that needs to be amended to replace references to LIBOR, the guidance confirms that a business may still rely on the clearance provided that:

• 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

However, 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.

Equally, where an Advance Thin Capitalisation Agreement has been given for a funding arrangement based on LIBOR, the agreement can continue to be relied upon and the company will not need to submit a new application provided that the amendments to the loan agreement are undertaken on arm's length terms. However, the Advance Thin Capitalisation Agreement will no longer apply if there are any other amendments to the funding arrangement.

Other

The guidance also covers a range of other technical issues that may arise such as the operation of the Disregard Regulations, the Hybrid Mismatch rules, DAC6, equity holder rules, distribution rules and grandfathering issues. Equally, however, there is recognition that the guidance cannot anticipate every possible tax impact of changes introduced to deal with the withdrawal of LIBOR and that it is limited to issues with reasonably widespread application. It would be difficult for HMRC to comment on less common issues outside of the context of their particular facts.

HMRC will continue to keep the guidance under review as businesses transition away from LIBOR and other reference rates in the coming months and will update the guidance should it be appropriate to do so