3 SOFR as a replacement of LIBOR: Transfer Pricing considerations

SOFR as a replacement of LIBOR: Transfer Pricing considerations

RAJEEV JAIN - CA, SHIKHA MEHTA - Transfer Pricing Professional

3

For the past many years, London Interbank Offer Rate (LIBOR)1 was used as a reference rate for variety of financial products around the world. With the unprecedented end of LIBOR by 2021, financial regulators as well as market participants are looking for the alternate reference rate(s) to replace the LIBOR in their existing as well as future contracts (i.e., loans, derivatives, mortgages, etc.). Since there is no single alternate reference rate (ARR) available in the market like LIBOR with various currencies and maturities, countries are introducing their own local currency denominated ARRs and have set-up transition committees to replace LIBOR specific rates. Some of the ARRs introduced by countries are listed below:

Country LIBOR Rate ARR

United States USD LIBOR SOFR (Secured Overnight Financing Rate) United Kingdom GBP LIBOR SONIA (Sterling Overnight Index Average) Japan TIBOR TONA (Tokyo Overnight Average Rate) Europe EURIBOR ESTER (Euro Short Term Rate) Canada CDOR CORRA (Canadian Overnight Repo Rate Average) Switzerland CHF LIBOR SARON (Swiss Average Rate Overnight)

Further, following the approach adopted by the US regulators and other countries, the Reserve Bank of India (RBI) has also tasked Indian Bank’s Association (IBA) to recognise and measure the impact of LIBOR’s cessation on the Indian markets. The IBA has since formed three workstreams on

(i) LIBOR transition arrangements (ii) rates and methodology (iii) outreach to market participants

IBA has also circulated guidance note among its member banks to enable them assess their preparedness for LIBOR transition on various parameters, viz., exposure assessment and assessment of the accounting, tax, information technology (IT) related implications. The ‘rates and methodology’ workstream is developing an acceptable alternative for Mumbai Interbank Forward Offer Rate (MIFOR) – which has LIBOR as one of its components – as a key benchmark used in the interest rate swap (IRS) markets. From a transfer pricing standpoint, all existing inter-company loan agreements expiring after 2021 (i.e. after the end of LIBOR) will be directly impacted by this transition. This will necessitate companies to re-align all such inter-company agreements.

Challenges faced by MNEs 2

u With the multiple ARRs introduced by different countries to replace their respective currency LIBOR rates, it becomes a tedious task for MNEs to revise multicurrency agreements with multiple adjustment methodologies. u Since the British regulator has already announced that it will no longer require banks to submit interbank lending information after 2021, many banks have already opted out themselves in providing quotes. Accordingly, considering fewer data, reliability of LIBOR even for existing agreements is also questionable.

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u While drafting new inter-company agreements, companies usually replicate practices followed for comparable third-party loan agreements, however, in the transition phase MNEs will face challenges in deciding on terms of the agreements as well as spread that needs to be added to the base rate as the comparable data may not available.

SOFR 3 as a replacement of LIBOR

In 2014, the U.S. Federal Reserve commissioned the Alternative Reference Rate Committee (ARRC) to identify alternative reference rates for USD LIBOR. On 22 June 2017, the ARRC identified SOFR as its recommended alternative to LIBOR after considering a comprehensive list of potential alternatives and the New York Federal Reserve began publishing SOFR in April 2018. SOFR is a broad measure of the cost of borrowing cash overnight collateralised by U.S. Treasury securities. It is representative of general funding conditions in the overnight Treasury repurchase market. SOFR is considered as a replacement benchmark on the following premise:

u Averaging over $1 trillion of daily trading, transaction volumes underlying SOFR are far larger than the transactions in any other U.S. money market. u It is based on observable transactions rather than based on estimates like LIBOR.

Though SOFR is so far considered as a replacement rate for USD LIBOR, it can’t be just replaced without making appropriate adjustments as the two rates differ in many ways as follows:

LIBOR

Bank-to-bank lending rate based on estimation

Unsecured

Includes credit risk

Forward term rate (1-month, 3-month, 1-year, etc.), borrower know the interest rate in advance

SOFR

Overnight secured rate based on observable transactions

Secured by treasury securities No credit risk (risk-free rate) Backward looking rate (overnight), borrower will not know interest payment until the end of interest period

Since, the two rates differ on account of credit risk and term maturity, an adjustment to that effect is required to make SOFR comparable to the USD LIBOR. The ARRC in their consultation paper has suggested a fallback approach along with the spread adjustment methodology to amend the existing agreements (denominated in USD LIBOR) with SOFR.

Fallback approach to be adopted

The ARRC has recommended a “fallback language” to amend the existing agreements, with the following two options:

u Hardwire approach – The hardwire approach provided the language to amend the existing agreements with specific fallback rates and spread adjustment to be adopted at the trigger event4 .

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Taxmann’s flagship commentary on Direct Taxes, has been the most trusted & bestselling commentary for experienced practitioners, for more than 20 years now. This book aims at not only making the reader understand the law, but also helps the reader develop the ability to apply the law. In other words, this books aims at providing the reader the following:  Acquire a familiarity with the various direct tax provisions  Awareness of direct tax provisions  The nature and scope of direct tax provisions  Up-to-date knowledge of how a statutory provision has been interpreted by different courts of law, on different occasions The Present Publication is the Latest Edition for Assessment Years 2021-22 & 2022-23), authored by Dr. Vinod K. Singhania & Dr. Kapil Singhania, incorporating all the amendments made by the following:  The Finance Act, 2021  The Taxation and Other Laws (Relaxation and Amendment of Certain

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u Amendment approach - The amendment approach does not identify the successor rate5 or spread adjustment. Instead, it provides an amendment process for negotiating the fallback rate in the future. It expands the language to include specificity around the process and parameters for selecting the benchmark replacement, specific trigger events for the transition, and inclusion of a benchmark replacement adjustment.

Companies could opt for any of the above approaches to amend their existing intercompany agreements, however, one need to customise the fallback language based on the domestic market requirements. Also, a spread adjustment is required to be calculated to make the SOFR comparable with USD LIBOR.

Spread adjustment methodology

The International Swaps and Derivatives Association (ISDA) has recommended a spread adjustment methodology, which will be calculated based on a 5-year period of historical differences between LIBOR and a compound average of SOFR set in arrears. Although the methodology would be same across different tenures of LIBOR, it would be applied to each LIBOR tenure separately, so that there will be a separate recommended spread adjustment calculated for 1-month, 2-month, 3-month, 6-month and 1-year LIBOR. Bloomberg has already started calculating and publishing a daily adjustment value for each LIBOR tenure. The recommended spread adjustments would not and are not intended to apply to new contracts referencing SOFR. The above methodology recommended by ARRC is specific to the agreements denominated in USD LIBOR. For the intercompany agreements denominated in currencies other than USD, one would need to analyse the currency specific ARRs and guidelines recommended by the relevant country. In general, the companies should be proactive and analyse the impact of base rate changes in their existing as well as new contracts. The companies should consider following actions from transfer pricing (TP) perspective:

Actions to be taken from TP perspective

u Re-alignment of existing agreements: Companies should re-align existing inter-company agreements to include appropriate fallback language along with the spread adjustment methodology and evaluate the impact of changes from the perspective of both the parties involved (i.e., lender and borrower) so that neither of the party is disadvantaged. The fallback clauses need to be customised to domestic market requirements. Also, one should consult the relevant tax, accounting and regulatory experts to analyse the potential impact of any amendments in the existing agreements. u Drafting new contracts using new ARRs: New contracts to be drafted using new ARRs instead of LIBOR even if they expire before the end of LIBOR as the rate will become less reliable. New loans will also require changes in documentation, payment structures, funding vs. lending mismatch, and other changes. Upgrading systems and processes: Companies should analyse their existing IT systems and processes that are currently based around LIBORs as the same may require upgrades in order to deal with ARRs that are backward looking and overnight-only, where amounts payable as interest are only known shortly before the payment date.

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u Set-up internal policy guidance: An internal policy providing guidance on implementing new ARRs and fall back provisions should be prepared in order to standardise an organisation-wide approach. Companies should also educate their internal team members on an ongoing basis on the developments in this regard. u Other aspects: Thought should also be given to the non-contractual uses of LIBOR and the operational and process impact of the phase-out. For example, LIBOR may be used for accounting purposes and for internal reporting or analysis.

Conclusion

Since 2021 has already begun, companies should start analysing the transfer pricing impact on their inter-company agreements and decide on the transition plan to tackle the issues arises from this change. In order to replace USD LIBOR with SOFR in the existing agreements, one should consider the recommendations made by ARRC with respect to the fallback language and spread adjustment methodology. However, the same needs to be customised to domestic market requirements. Furthermore, comparable data will also be available soon as the market has started dealing in SOFR. Some US institutions have already started issuing securities and writing contracts that based on SOFR. Even India has started dealing in SOFR. Two of the Indian banks i.e. SBI and ICICI has recently entered in their first alternative risk-free rate transactions utilising the SOFR, which is an important step for the Indian market to support the LIBOR’s transition and move ahead with the implementation phase. Needless to say that, the companies should keep an eye on the developments taking place in the market in this regard and accordingly, move ahead with the transition.

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1. LIBOR is a set of several benchmarks that reflect the average interest rate at which large global banks can borrow from each other. It is produced once a day by the Intercontinental Exchange (ICE) and regulated by the Financial

Conduct Authority. 2. Multinational enterprises 3. SOFR is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their bond assets. 4. A trigger event is an occurrence that precipitates the conversion from LIBOR to a new reference rate. 5. The successor rate is the reference rate that would replace LIBOR in contracts.

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