Financial Guarantees and Intercompany Considerations

Introduction

In the current market, creditors, such as banks, are increasingly demanding security or guarantees when providing funding to corporate clients. Especially when dealing with a below investment grade borrower, it is quite common that a comprehensive security package, including all kinds of pledges (shares, cash flows, assets, etc.) provided by multinational group subsidiaries or parent company are routinely included in the deal. As such, it could occur that these guarantees are provided without key stakeholders’ awareness within the multinational group, while the resulting contingent liability might be described in the subsidiaries’ financial statements and tax authorities increasingly scrutinizing this complicated intercompany phenomenon.

Considering the complexity when dealing with guarantees, it is important that tax, treasury, accounting and legal departments of multinational groups regularly align and review intercompany financing structures identify and monitor if and by which entity security is provided, and conclude on the arm’s length nature thereof, including whether the guarantee provided would be compensable for transfer pricing purposes.

Guarantees can be distinguished in different ways, primarily on the basis of their nature, features and purpose. Guarantees may be very specific or very wide in scope. In the context of intragroup guarantees, the following are the most common:

• Downstream guarantee: a subsidiary receives a guarantee from a parent company;
• Upstream guarantee: the parent receives a guarantee from a subsidiary (or multiple subsidiaries);
• Cross guarantee: two or more related companies guarantee each other’s obligations.

Transfer pricing aspects of Guarantees

When a guarantee is identified, it is prudent to assess its transfer pricing implications and understand if potentially an arm’s length guarantee fee might be due. The OECD has provided a multi-step framework for that purpose in Chapter X of the OECD Transfer Pricing Guidelines:

1. Determine the nature of the guarantee;
2. Accurately delineate the guarantee;
3. Arm’s length pricing .

Nature of a guarantee

The OECD has clarified that only formal written guarantees that constitute a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor are relevant for transfer pricing purposes. The analysis thus starts from a careful review of the guarantee provided and legal agreements related thereto.

Accurate delineation

When dealing with guarantees, Chapter X of the OECD Transfer Pricing Guidelines advocates to undertake the process of “accurate delineation” of the effect of the related party guarantee, e.g. increase the debt capacity of the borrower or to reduce the cost of funding for the borrower, or both.

A careful review of the reasons behind the guarantee, the reason for which it is provided, the economic impact of such guarantee on the related financing transaction and the parties involved are all relevant in this second step of the guarantee analysis.

There are several business drivers for providing a financial guarantee, for instance:

• if a guarantee results in an economic or commercial benefit to the borrower, e.g. a credit enhancement beyond the impact of implicit support for the borrower, then an arm’s length guarantee fee might be compensable.
• However, if the guarantee results in an increased debt capacity or allows the borrower to tap into a debt capacity which is otherwise unavailable to it without the guarantee (on a stand-alone basis), the OECD proposes a re-characterization of the incremental capacity by hypothesizing a loan to the guarantor followed by an equity contribution from guarantor to the guarantee recipient. The guarantee fee should then only apply to the portion accurately delineated as debt.

Furthermore, Chapter X of the OECD Guidelines emphasizes the importance of the benefit test to be met in order to be able to conclude whether a beneficiary would be willing to pay for the guarantee provided. There are indeed several scenarios in which the benefit test would not be met and thus no guarantee fee would be due at arm’s length. Clearly, the perspective of the guarantor, which is contractually exposed to the default risk on the guaranteed transaction, is quite different as it assumes the default risk as a result of providing the guarantee for which it might want to be compensated.

In case of cross guarantees, the OECD indicates that evaluating the effect of such arrangements is exponentially difficult as the number of parties involved increases. This thus requires a careful analysis of the overall arrangement, but a resulting conclusion might be that any benefit or credit enhancement resulting therefrom may ultimately amount to no more than what would have already been achieved through passive association.

Arm’s length pricing

In situations where it is concluded that the guarantee is relevant for transfer pricing purposes (step 1) and results in an economic or commercial benefit to the borrower (step 2), an arm’s length guarantee fee can be established through the methods provided, e.g., through the CUP method, Yield approach or Cost Approach. The latter two are often applied in practice and in combination to factor in the perspective of both the guarantor and the beneficiary thereof (borrower).

Takeaways

There are various different types of guarantees and multiple sound business reasons for which guarantees are provided. Although the OECD guidance does not cover all types of guarantees (for example, there is no specific guidance for upstream guarantees, nor performance guarantees), the OECD does provide a general framework for dealing with guarantees.

Another important takeaway is that the OECD recognizes that guarantees do not necessarily have transfer pricing consequences. It is therefore important to thoroughly review these transactions through the multi-step approach advocated.

Are you aware of guarantees provided?

A first step would be to take inventory in terms of financial transactions and any security that has been offered to the external creditors. Departments that have insight into this information, include for instance, treasury, accounting and legal that more often deal with guarantees.

What is your policy?

In the event that there is a clear overview of guarantees provided, the next question is whether there is a consistent policy available with regard to possible transfer pricing aspects. If no policy is available, it is advisable to set it up for different guarantees. Even if it is clear that no guarantee fee is required (e.g. in case of effect of group membership), a robust policy and documentation greatly facilitates any internal or external discussion.

Contact us:

Loran van der Scheer
Senior Consultant - Transfer Pricing
Phone: +31(0)88 288 8947
LvanderScheer@deloitte.nl