Christos Theophilou of Taxand explores the effect of financial guarantees on multinational enterprises’ transfer pricing policies and analyzes how taxpayers can ensure compliance in their tax planning strategies.
Financial transactions are considered to be one of the most significant areas of transfer pricing controversy between taxpayers and tax authorities. On Feb. 11, 2020, the OECD released transfer pricing rules with respect to financial transactions that were then included in chapter X of the 2022 OECD Transfer Pricing Guidelines, and in 2021, the UN included Chapter 9.13 of the 2021 UN Practical Manual to provide guidance for taxpayers and tax authorities on how to analyze and price financial guarantees in transfer pricing.
The potential for abusive transfer pricing practices involving intragroup financial guarantees means tax authorities are vigilant and have appropriate mechanisms in place to detect and address them.
An intragroup financial guarantee is where a related party guarantor agrees to assume the financial obligations (deriving from the guaranteed instrument) of a related party (the guaranteed entity) towards a lender, in the event that the guaranteed entity defaults on its obligations towards this lender. In a transfer pricing context, only explicit financial guarantees are applicable, because they represent a legally binding commitment from the perspective of the guarantor to assume a specific obligation of the guaranteed debtor in case the latter defaults; whereas the so-called “soft” commitments or “implicit” guarantees (for example, keep-well agreement or comfort letters or letter of intent) are considered to be a passive association and therefore not remunerated.
In practice, there are three types of explicit financial guarantees: downstream guarantee, upstream guarantee, and cross-guarantee.
In a different case where the purported financial guarantee is not proving any benefit to the borrower, the guarantor would be found as providing no more than an administrative service to the borrower, and the Organization for Economic Cooperation and Development guidelines, chapter VII, services, apply instead. Finally, in applying the arm’s-length principle, the 2022 OECD guidelines provide for a four-step approach:
Step 1—identifying commercial and financial relations; Step 2—recognizing the accurately delineated transaction; Step 3—selecting the most appropriate transfer pricing method; and Step 4—applying the most appropriate method. This article focuses on considering the accurately delineated transaction (steps 1 and 2 above) that will identify whether an intragroup financial guarantee will be recognized—that is, chargeable or deductible, or not recognized—that is, disallowed. For purposes of completeness, steps 3 and 4 deal with the arm’s-length price of guarantees (quantification of the benefit and calculating the guarantee fee) by using the following methods: CUP method; yield approach; cost approach; valuation of expected loss approach; and capital support method.
Case Law Examples In the Canadian GE Capital case (General Electric Capital Canada Inc v The Queen, 2009 TCC 563 (Tax Court of Canada), and The Queen v General Capital Canada (2010) FCA344 (Federal Court of Appeal), it was examined whether the guarantee fee paid of 100 basis points (i.e. 1%) regarding the financial guarantee provided by the US GE Capital to its Canadian indirect subsidiary was at arm’s length. The court concluded that the implicit support should be ignored and therefore be in line with the OECD guidelines. Yet implicit support, being an economically relevant factor when assessing credit rating, should be considered when assessing the credit rating of the guarantor and the borrower, therefore impacting the determination of the arm’s-length guarantee fee. Put differently, the court rejected the argument that the credit rating should be determined on a standalone basis.
In the EU Hornbach-Baumarkt case, the German tax authorities imposed a notional income adjustment because a parent company Hornbach, established in Germany, issued comfort letters to its two foreign Dutch subsidiaries with no remuneration for issuing such letters, because the foreign subsidiaries were unable to obtain a bank loan due to their negative equity capital. Interestingly, the Court of Justice of the European Union decided that it is for the national court to determine whether the legislation at issue in the main proceedings affords the resident taxpayer the opportunity to prove that the terms were agreed on for commercial reasons resulting from its status as a shareholder of the nonresident company. Therefore, the CJEU considered the comfort letters to be explicit guarantees (and thus deviating from the OECD guidelines) where there may be commercial reasons for a parent company to agree to provide capital on non-arm’s-length terms.
Under step 1, accurate delineation of the explicit financial guarantees process it is considered whether the portion of the loan is considered to be an equity contribution from the guarantor to the borrower and, therefore, no financial guarantee fee would be charged. For example, if the guaranteed party (e.g., a subsidiary) was unable to obtain a loan from a third-party bank without its parent company issuing a downstream guarantee to such a bank, a guarantee fee would not be chargeable because it would be considered to be provided out of shareholder motives (i.e. a shareholder transaction under OECD guidelines paragraph 7.13).
In practice, this would be the case where the guaranteed subsidiary creditworthiness is below the investment grade ratings (for example, BB taking into consideration any implicit support) and the third-party bank would not have been willing to lend the money to the subsidiary in the absence of the parent downstream guarantee. Therefore, any guarantee fee charged by the parent to its subsidiary would normally be disallowed. If a portion of the loan provided by the third-party bank is accurately delineated as a loan, the guarantee fee should be limited to a fee on the portion that has been delineated as a loan.
Further, for an explicit financial guarantee to be recognized, an economic benefit should be derived from such a guarantee. From the perspective of the guarantor, its financial capacity should be established, and therefore, both the guarantor and borrower credit rating should be established and taking into consideration the effect of implicit support or passive association.
On the other hand, from the perspective of the borrower (the guaranteed party), an intragroup financial guarantee could result in two scenarios:
The guidance under OECD guidelines paragraph 7.6. that a service is beneficial can be helpful (in an earlier article we analyze the so-called benefit test), and in practice the following questions are important:
For example, in case a guaranteed subsidiary does not achieve better creditworthiness from an explicit downstream financial guarantee provided by its parent. Such a subsidiary would not have requested a similar financial guarantee because it does not confer a benefit to the subsidiary. Therefore no guarantee fee would be due.In light of the above, by following the guidance provided in the OECD Guidelines or the UN TPM, taxpayers can ensure compliance with transfer pricing rules and reduce the risk of disputes with tax authorities. Notably, to ensure compliance, the following steps are critically important for taxpayers to ensure compliance:
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