Transfer Pricing and Intercompany Loans: The Use of Modern Base Rates like SOFR, SONIA, and Beyond

As the global financial landscape has shifted away from London Interbank Offered Rate (“LIBOR”) reference rate, multinational enterprises (“MNEs”) are adapting how they structure intercompany loans. With regulators pushing for robust and transparent alternatives, reference rates such as Secured Overnight Financing Rate “SOFR” (USD), Sterling Overnight Index Average “SONIA” (GBP), Euro Short-Term Rate  “€STR” (EUR), and Tokyo Overnight Average Rate “TONA”, also known as “TONAR” (JPY) are now front and center in transfer pricing strategies.

This transition has direct implications on loan pricing, risk assessment, and compliance with the OECD Transfer Pricing Guidelines (“OECD Guidelines”).

Background: The demise of LIBOR

A base rate is the reference interest rate used to determine the total interest charged on a floating-rate loan. The final lending rate typically takes the form:

Base Rate + Credit Spread = Final Interest Rate

The base rate reflects the time value of money and the currency environment, while the credit spread compensates for borrower-specific credit risk. When setting intercompany loan terms, companies must defend both components for arm’s length compliance.

The LIBOR was the dominant benchmark for floating-rate loans and other financial products. However, due to manipulation concerns and the dwindling volume of underlying transactions, regulators initiated a global effort to phase it out.

Key milestones:

• LIBOR ceased for most currencies by end-2021.
• USD LIBOR fully discontinued as of June 30, 2023.

MNEs with intercompany loans referencing LIBOR had to re-document, re-price, or transition their contracts to alternative rates.

Overview of Alternative Reference Rates (“ARR”)

These rates are transaction-based, more robust, and provide a more accurate representation of market conditions compared to LIBOR. Unlike LIBOR, which relied on submissions from a panel of banks and was therefore subject to judgmental inputs and potential manipulation, ARRs are derived from observable market transactions, enhancing transparency and reliability.

Jurisdictions have adopted benchmark rates aligned with the liquidity and structure of their respective money markets:

• Secured rates such as SOFR and SARON, based on repo transactions, are generally considered less risky.
• Unsecured rates such as SONIA, €STR, and TONAR capture dynamics of unsecured funding markets.

The global shift to ARRs strengthens market integrity, reduces benchmark-related risks, and establishes a more consistent and reliable foundation for pricing loans, derivatives, and other financial instruments.

Implications for Transfer Pricing

Based on the arm’s length principle, interest rates on intercompany loans must be consistent with the terms that independent parties would have agreed upon under comparable circumstances. In practice, this involves:

• Preferably using the comparable uncontrolled price (“CUP”) method to identify comparable uncontrolled debt transactions to benchmark the arm’s length interest rate to be determined for the intercompany loan.
• Comparing the currency, origination date, tenor, credit rating or implied creditworthiness of the borrower, loan type, security of the debt, collateral, payment options, use of proceeds, etc.
• Adjusting for base rate + credit spread.

Similar structures apply for loans in GBP (SONIA), EUR (€STR), etc. It is crucial to align the base rate with the loan currency and market convention to ensure arm’s length terms of the loan.

Practical Considerations

• Transitioning to New Loan Terms

For legacy LIBOR-based intercompany loans, companies should:

• Amend contracts to reference an ARR: Legacy loan agreements that still reference LIBOR should be updated, ensuring continuity and compliance with global benchmark reforms.
• Reassess and document the revised terms: When transitioning from LIBOR to SOFR or from EURIBOR to €STR, companies must ensure that the new base rate plus credit spread remains arm’s length. Since credit spreads under LIBOR are not directly comparable to those under ARRs, a fresh benchmark is needed to support the revised spread.
• Avoid retroactive application without economic rationale: Changing historical loan terms to apply ARRs retroactively could create artificial results. Any retrospective adjustment should only be made if there is a clear and defensible economic justification, supported by contemporaneous evidence.

• Currency Consistency

Base rates must match the currency denomination of the loan. Using SOFR for a EUR loan would not be arm’s length. Differences in compounding conventions and availability of term structures can complicate implementation across jurisdictions.

Companies should maintain:

• Market data showing base rate and credit spread.
• Internal policies justifying the choice of base rate.
• Fallback language in case the ARR becomes unavailable.

Conclusion

The shift to alternative base rates like SOFR and SONIA has transformed the landscape of intercompany financing. MNEs must adapt by:

• Updating their transfer pricing models.
• Ensuring currency-appropriate base rates.
• Supporting interest rates with robust benchmarking analyses and documentation.

Proactive compliance with the LIBOR transition not only mitigates potential tax and regulatory exposure but also demonstrates prudent treasury and financial management. The discontinuation of LIBOR represents more than a procedural adjustment; it marks a structural change in the way MNEs manage intra-group financing. Establishing and maintaining a well-documented, market-consistent approach to intercompany loan pricing is therefore essential to ensure alignment with the arm’s length principle and to effectively manage tax and financial risks.

This article was written by Alejo Salvia, Lead Senior Associate – PSG Transfer Pricing.