How the change from SOR to SORA impacts intercompany debt transactions
As the key reference rate for financial transactions phases out, companies must consider the transfer pricing and operational implications.
In July 2017, the Financial Conduct Authority announced that the London Interbank Offered Rate (LIBOR) will be phased out by 31 December 2021. Following this, the Intercontinental Exchange Benchmark Administration, which administers the LIBOR, announced it will cease publication of all currency LIBOR settings (i.e., Euro, Japanese yen, Pound sterling, Swiss franc and certain United States dollar tenors) on 31 December 2021. To ease the transition to alternative reference rates (ARRs), the deadline for phasing out of the frequently used United States dollar LIBOR tenors has been extended to 30 June 2023 (applies to legacy financial contracts only).
Given that trillions of dollars of financial transactions reference LIBOR, a complex exercise is underway to transition existing contracts to ARRs (being the new reference rates proposed by regulators for each currency). Closer to home, Singapore’s equivalent to LIBOR is the Swap Offer Rate (SOR). However, with the computation methodology for SOR relying on United States dollar LIBOR, an ARR is required for Singapore dollar denominated financial products.
The Association of Banks in Singapore and the Singapore Foreign Exchange Market Committee have identified Singapore Overnight Rate Average (SORA) as the ARR of choice to replace SOR. SORA is a volume weighted average rate of borrowing transactions in the unsecured overnight interbank Singapore dollar market. SORA will be administered by the Monetary Authority of Singapore and will be computed based on actual overnight interbank transactions in a highly liquid market, thereby meeting the standards of international best practice for ARRs. The overnight SORA index will be published daily, along with compounded one-month, three-month and six-month tenors.
Implications for transfer pricing (TP) and companies’ broader operations
The transition to SORA will create complex challenges from both TP and operational perspectives. These challenges partially stem from the underlying differences in SOR compared to SORA.
SORA is generally viewed as free of credit risk due to its overnight tenor. On the other hand, SOR, which is derived from United States dollar LIBOR, incorporates an interbank credit spread for unsecured lending over various tenors. For this reason, SORA does not inherently contain the same level of bank credit risk that is prevalent in SOR. The bank credit risk component reflects a variety of factors such as liquidity and fluctuations in supply and demand, typically resulting in volatility in LIBOR rates during times of market stress. In addition, given that SORA is computed on an overnight basis, while SOR reflects the cost of lending money for longer time periods, there is an additional tenor difference along with the credit spread differential.
When companies transition financial products from referencing SOR to SORA accordingly, the inherent credit spread and tenor differences between the two reference rates may impact the profitability of financial products, affect risk models as well as treasury and risk management activities.
The transition will also require consultation with legal representation on the basis of contract extensions and refinancing aspects, including the refinement of underlying terms and conditions and the need for any fallback provisions to be included in the revised contracts. Operations and technology departments will need to ensure systems are appropriately updated in time for the transition. Finally, accounting and tax will be impacted with uncertainties surrounding financial reporting and underlying tax implications. These include value transfers affecting the fair value of financial and non-financial instruments, along with hedge accounting and whether derivatives continue to match the underlying exposure.
With respect to TP, companies will need to review their existing intercompany loan and credit facilities, cash pooling arrangements, intra-day funding and any options, forwards or derivative products currently referencing SOR (or any other LIBOR that is due to be phased out). Specific to intercompany funding transactions, the inherent differences due to the transition from SOR to SORA can cause value transfers or cashflows to fall as a result of rolling existing financial products over to SORA without any corresponding adjustments performed. Companies will need to consider if one-time adjustments are required to meet the previously agreed arm’s length pricing when the transition to SOR occurs.
With respect to cash pooling arrangements and intra-day funding, TP policies referencing daily SOR (or LIBOR) will need to be amended as liquidity in the market decreases and publication of the rates cease. Certain intra-group transactions linked to third-party funding transactions (e.g., flow-through funding, back to back arrangements, risk transfers or derivatives such as interest rate swaps) will likely require immediate focus and consultation with your third-party lenders.
Companies complying with the Singapore TP Guidelines will also need to consider the impact on their existing TP documentation and benchmarking studies. Given that SORA is not a direct substitute for SOR, benchmarking studies may need to be updated to identify and analyse the terms and conditions of using SORA to assess the impact on pricing (i.e., credit and tenor adjustments).
More importantly, the phasing out of SOR and transition to SORA is not expected to immediately result in a refinancing event and issuance of a new loan or financial product. However, this does allow companies to review their existing financial products and contracts and potentially look to refinance where the terms and conditions allow for this to occur. Notably, taxpayers will need to consider how the terms and conditions of legal agreements have been written, and the underlying intention of the parties to the transaction, as these will be key factors when determining if this change results in an amendment or replacement i.e., refinance of an existing financing agreement.
Finally, regardless of whether companies amend existing financing arrangements or refinance these transactions, intercompany agreements will need to be reviewed and updated accordingly.
With the transition to SORA less than a year away, companies need to first review all their existing financial products referencing SOR (or any other LIBOR that is due to be phased out) and consider the operational impact associated with the change such as internal funding models, transaction flows, calculations, systems and supporting documentation (TP documentation, legal agreements etc.) that need to be reviewed and potentially updated.
In addition, while the focus so far has been about the effect the transition will have on internal operations and pricing, companies will have to consider the potential increase in TP controversy, particularly where different countries (or regions) adopt different benchmark rates and stagger adoption dates. Double taxation may arise where tax authorities adopt different views on the appropriate reference or benchmark rate that should be adopted for the same transaction.
The co-authors of this article are Rajesh Bheemanee, Partner, Financial Services Transfer Pricing from Ernst & Young Solutions LLP and Charles Parnell, Manager – Transfer Pricing from Ernst & Young Corporate Advisors Pte. Ltd.