The Chartered Accountant • Journal of ICAI September 2022 • Vol. 71 • No. 3 • pp. 49–55 (Journal pp. 281–287)
INTERNATIONAL TAXATION

Corporate Guarantee and Transfer Pricing

*SP Singh Author is Ex-IRS Officer. He may be reached at spsingh54@gmail.com and eboard@icai.in
**CA. Ankit Arora Chartered Accountant. He may be reached at eboard@icai.in

Need for credit and Financial Guarantees

Need for credit: For the purpose of growth as well as for day-to-day running of operations, businesses need regular flow of fund/cash. For this, an enterprise may prefer to borrow fund from external sources, rather than use its internal resources. Debt has certain advantages compared to equity financing. It has a lower financing cost as it is finite and has to be paid off at some point of time allowing owners to retain full control over company, further, it allows tax breaks and is much less formal in organising1.

Due to various reasons, such as capital base, profitability, perceived capacity to pay debt by the company, lenders ask for guarantee. Financial guarantees include bank guarantee, corporate guarantee, personal guarantee etc., the first two being more common. Further, the guarantee can be implicit or explicit. Implicit guarantee refers to the situation when the credit rating of a company that is part of a Multinational Enterprise (“MNE”) group may be considered higher (and interest rate there for lower) than its stand-alone rating. In such a situation, a bank or rating agency believes that associated enterprises would support the company in a period of financial stress even in the absence of an explicit guarantee.2 On the other hand, explicit guarantees are formally documented with required parameters expressed clearly and comprehensively.

Normally, bank guarantees are explicit while, corporate guarantees can be implicit or explicit. The other difference between bank guarantee and a corporate guarantee is that while in the former, the bank is the responsible party for repayment in case of default; in a corporate guarantee, “the company which agreed to repay the loan has the responsibility in the situation of repayment”.3 A bank guarantee is an assurance provided by a lending institution that the liabilities of a borrower will be paid back in time. It offers the lender the surety that if the borrower fails to clear the debt, the bank will make the payment or their client. On the other hand, in the corporate guarantee indemnity is granted by the corporate guarantor in favour of the lender. It means an irrevocable and unconditional guarantee given or, as the context may require, to be given by a corporate guarantor in form and substance satisfactory to the Bank as a security for the outstanding Indebtedness and any and all other obligations of the borrower. In a way corporate guarantee is an irrevocable and unconditional guarantee given or, as the context may require, to be given by the corporate guarantor in form and substance satisfactory to the lender as security for the outstanding indebtedness and any and all other obligations of the borrowers.4

The corporate guarantee benefits the borrower as it enables it to get loan, at the same time it benefits the lender as it provides assurance that the loan is secured. In the absence of the guarantee the borrower might not have got the loan or might have got at a much higher cost. This applies more to the borrowers with low credit ratings. As a guarantee is a legal promise made by a third party (guarantor) to cover a borrower’s debt or other types of liability in case of the borrower’s default it serves as additional protection in a loan, making a loan more attractive to potential lenders. The lenders would be more willing to provide guaranteed loans even to borrowers with a poor credit profile, as the presence of a guarantor diminishes the probability of a lender of not being repaid.5 In this article transfer pricing ramifications of explicit corporate guarantee are discussed.

Perspectives of Borrower and Lender

From the perspective of borrower, a financial guarantee may affect the terms of borrowing. It reduces the cost of debt-funding for the borrower and hence it may be inclined to pay for that guarantee. On the other hand, from the perspective of lender, “the consequence of one or more explicit guarantees is that the guarantor(s) are legally committed; the lender’s risk would be expected to be reduced by having access to the assets of the guarantor(s) in the event of the borrower’s default. Effectively, this may mean that the guarantee allows the borrower to borrow on the terms that would be applicable if it had the credit rating of the guarantor rather than the terms it could obtain based on its own, non-guaranteed, rating.”6

The entities involved in a corporate guarantee

The entities involved in a corporate guarantee are:

  1. The borrower: who seeks and receives credit and who is responsible for repaying the loan, also called the guaranteed party;
  2. The lender: who extends the credit;
  3. The guarantor: who agrees to repay the loan extended by the lender to the borrower, if the latter fails to repay the loan.

Cross-guarantee in MNE Groups

In an MNE group, normally the parent stands as corporate guarantor for its subsidiaries. There may be cases where two or more entities in the group guarantee each other’s obligations. This is referred as cross-guarantee. From the lender’s perspective, it has access to the assets of every cross-guaranteeing entity in the event of a default by a guaranteed borrower. This potentially gives the lender greater comfort than a single guarantee as it can choose where within the cross-guaranteeing MNE group it seeks, if necessary, to make its recoveries. The effect of a cross-guarantee from a borrower’s perspective is that it now has multiple guarantees on its borrowings and may stand as guarantor for multiple borrowings itself.7

OECD on Financial Guarantee

On 20 January 2020 the Committee on Fiscal Affairs approved “Transfer Pricing Guidance on Financial Transactions – Inclusive Framework on BEPS: Actions 4, 8-10”. This was incorporated in Chapter X8 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which was released in January 2022 (herein after referred to as OECD 2022). It observes that to determine the transfer pricing consequences of a financial guarantee, it is first necessary to understand the nature and extent of the obligations guaranteed and the consequences for all parties in accordance with the general principles of arm’s length. As for any transaction, for determining the arm’s length price of a financial guarantee the selection of the most appropriate method should be consistent with the actual transaction as actually delineated, particular through functional analysis.

The methods discussed in OECD 2022 are the Comparable Uncontrolled Price (“CUP”) method, Yield approach, Cost approach, Valuation of expected loss approach and Capital support method.

1. The Comparable Uncontrolled Price (“CUP”) Method

The CUP method can be used where there are either internal or external comparables; independent guarantors providing guarantees in respect of comparable loans to other borrowers or where the same borrower has other comparable loans which are independently guaranteed. While applying this method, factors which should be kept in mind are: the risk profile of the borrower, terms and conditions of the guarantee, term and conditions of the underlying loan (amount, currency, maturity, seniority etc.), credit rating differential between guarantor and guaranteed party, market conditions, etc. When available, uncontrolled guarantee transactions are the most reliable comparable for determining arm’s length guarantee fees.9 The problem in applying this method is that publicly available information about a sufficiently similar guarantee is unlikely to be found between unrelated parties given that unrelated party guarantees of bank loans are uncommon.

2. The Yield Approach

In the Yield approach the benefit that the guaranteed party receives from the guarantee in terms of lower interest rates is quantified. The method calculates the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. This is carried out in two steps:

  • Step 1: The interest rate that would have been payable by the borrower on its own merits, taking into account the impact of implicit support as a result of its group membership is determined.
  • Step 2: To determine, by a similar process (unless directly observable in the case of a loan from a third party), the interest rate payable with the benefit of the explicit guarantee.

The interest spread can be used in quantifying the benefit gained by the borrower as a result of the guarantee. In determining the extent of the benefit provided by the guarantee, it is important to distinguish the impact of an explicit guarantee from the effects of any implicit support as a result of group membership.

The benefit of implicit support will be the difference between the borrowing terms attainable by the borrowing entity based on its credit rating as a member of the MNE group and those attainable on the basis of the stand-alone credit rating it would have had if it were an entirely unaffiliated enterprise. If the borrower has its own independent credit rating from an unrelated credit rating agency, this will usually reflect its membership of the MNE group and so ordinarily no adjustment would be needed to this credit rating to reflect implicit support.

The result of this analysis sets a maximum fee for the guarantee (the maximum amount that the recipient of the guarantee will be willing to pay), namely, the difference between the interest rate with the guarantee and the interest rate without the guarantee but with the benefit of implicit support (and taking into account any costs). The borrower would have no incentive to enter into the guarantee arrangement if, in total, it pays the same to the bank in interest and to the guarantor in fees as it would have paid to the bank in interest without the guarantee. Therefore this maximum fee does not of itself necessarily reflect the outcome of a bargain made at arm’s length but represents the maximum that the borrower would be prepared to pay.

3. The Cost Method

The Cost method aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee (loss given default). Alternatively, the expected cost could be determined by reference to the capital required to support the risks assumed by the guarantor. Various possible models are used for estimating the expected loss and capital requirements. Pricing under each model will be sensitive to the assumptions made in the modelling process. Whatever valuation model is used, the evaluation of cost method sets a minimum fee for the guarantee (the minimum amount that the provider of the guarantee will be willing to accept) and does not of itself necessarily reflect the outcome of a bargain made at arm’s length. The arm’s length amount should be derived from a consideration of the perspectives (taking into account options realistically available) of the borrower and guarantor.

4. Valuation of expected loss approach

The Valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default. This would then be applied to the nominal amount guaranteed to arrive at a cost of providing the guarantee. The guarantee could then be priced based on an expected return on this amount of capital based on commercial pricing models such as the Capital Asset Pricing Model (CAPM).

5. Capital support method

The capital support method may be suitable where the difference between the guarantor’s and borrower’s risk profiles could be addressed by introducing more capital to the borrower’s balance sheet. It would be first necessary to determine the credit rating for the borrower without the guarantee (but with implicit support) and then to identify the amount of additional notional capital required to bring the borrower up to the credit rating of the guarantor. The guarantee could then be priced based on an expected return on this amount of capital to the extent that the expected return so used appropriately reflects only the results or consequences of the provision of the guarantee rather than the overall activities of the guarantor-enterprise.

OECD Illustrative Examples (OECD 2022, pp. 440–441)

The OECD 2022 (page 440-441) explains the application of the arm’s length methods with the following examples:

Example 1

Company M, the parent entity of an MNE group, maintains an AAA credit rating based on the strength of the MNE group’s consolidated balance sheet. Company D, a member of the same MNE group, has a credit rating of only BBB on a stand-alone basis, and needs to borrow EUR 10 million from an independent lender.

Assume that the accurate delineation of the actual transaction shows that the effect of passive association raises Company D’s credit standing from BBB to A, and that the provision of the explicit guarantee additionally enhances the credit standing of Company D to AAA. Assume further that independent lenders charge an interest rate of 8% to entities with a credit rating of A, and of 6% to entities with a credit rating of AAA. Assume further that Company M charges Company D a fee of 3% for the provision of the guarantee so the guarantee fee more than completely offsets the benefit of Company D’s enhanced credit standing derived from the provision of such guarantee.

In that situation, the analysis under Chapter I may indicate that an independent enterprise borrowing under the same conditions as Company D would not be expected to pay a guarantee fee of 3% to Company M for the provision of the explicit guarantee since Company D is better off in the absence of the guarantee.

Example 2

Consider the same fact pattern as described in Example 1, but in this case assume that under the guidance in Section D.2, comparable uncontrolled transactions can be identified showing that the arm’s length price of a comparable guarantee would be in the range of 1% to 1.5%.

The accurate delineation of the actual transaction indicates that the enhancement of Company D’s credit standing from A to AAA is attributable to a deliberate concerted group action, i.e. the guarantee provided by Company M. Company D would be expected to be willing to pay an arm’s length guarantee fee to Company M for the provision of the explicit guarantee since Company D is better off than in the absence of the guarantee.

UN Practical Manual on Transfer Pricing (2021)

In the UN Practical Manual on Transfer Pricing (2021) (herein after referred to as UN 2021) discussion on financial guarantee in para 9.13.2 (pages 387-393) is very similar to that in the OECD 2022, discussed above. Inter alia, it suggests that the following economically relevant factors may be considered while determining the arm’s length nature of an explicit financial guarantee:

  • The contractual terms of the financial guarantee (including terms and conditions of the guaranteed instrument), as supported by the conduct of the parties;
  • The risk profile of the borrower, after accounting for the impact of any implicit support, by considering the functions performed, and assets used (any available external credit rating of the borrower or of the guaranteed instrument and/or information on the probability of default of the borrower may be relevant in this regard);
  • The risk profile and financial capacity of the guarantor;
  • The characteristics of the financial guarantee (including benefits provided by the financial guarantee, if any);
  • The economic circumstances of both the guarantor and the guaranteed entity and of the market(s) in which they operate; and
  • The business strategies pursued by the guarantor and guaranteed entity.

Disallowance of Intra-Group Guarantee Fees under UN 2021

The UN 2021 is of the view that an intra group financial guarantee fee is likely to be disallowed to the extent that:

  • The guaranteed entity is perceived as having a better creditworthiness solely because of its group affiliation (so-called ‘implicit support’), i.e. the financial guarantee does not improve the creditworthiness of the borrower beyond any benefits it already receives through implicit support;
  • The debtor has no debt capacity or credit status and, therefore, would not be able to access the capital market without the financial guarantee. That is, a third party would never provide a loan to this debtor absent the guarantee, for example due to its insufficient debt capacity. In situations like this, an accurate delineation of the transaction might lead to the conclusion that the guarantee provided by the parent company is a function performed in its own interest and that the parent company, by providing the guarantee, essentially and substantively is the borrower; and
  • The financial guarantee has been requested by the creditor for the sole purpose of ensuring that the parent company does not divert the funds of the borrower, i.e., moral hazard issues (although in this situation there may be some benefit to the borrower to the extent it obtains a better credit rating).

Transfer Pricing Approaches in a few countries regarding corporate guarantee

Financial guarantee has been one of the major focus areas for tax authorities around the globe. While countries vary in form and scope of their approaches in determining the arm’s length nature of the transactions, most of the countries recommend examining the following factors while examining guarantee transactions:

  • Benefit received;
  • Whether a third party be willing to pay guarantee fees;
  • Shareholder services;
  • Risk profile of the guarantor;
  • Nature of guarantee fees;

The salient features of the treatment of corporate guarantee in some of the countries are discussed hereunder:

USA

COVID 19 has seen a surge in financial guarantee and intercompany loan transactions in USA.10 Though US transfer pricing regulations under section 482 of the Internal Revenue Code specifies financing (intercompany loans, guarantees) as one of the categorises of intercompany transactions, it does not adequately address elements and process of transfer pricing of financial guarantees provided by a company to its Associated Enterprise.

Japan

Japanese tax authorities i.e. National Tax Agency (“NTA”) also focus aggressively on Japanese headquartered companies which do not charge guarantee fees from its affiliates abroad. Usually, yield approach which requires split of benefit received because of guarantee is more prevalent.

Korea

The regulations on financial guarantees were introduced in the domestic law in year 2012. Under the Korean law the arm’s length price of financial guarantee transaction may either be determined based on a) respective risk or expenses of guarantor or b) expected benefit derived by guarantee or c) a mix of the both. Korean law also provides for safe harbour provisions wherein, fee determined based on interest rate differential or computed in accordance with conditions prescribed by National Tax Service (“NTS”) are deemed to be at arm’s length.

Australia

The Australian Taxation Office (ATO) has in recent years issued a range of guidance concerning intra group financing transactions and related issues following its win in the landmark transfer pricing case against Chevron. However, there is no specific guidance on transfer pricing of financial guarantees. As, Australian transfer pricing rules generally follows the OECD guidelines where possible, so taxpayers with related party financial arrangements are advised to take into account the new OECD guidance where relevant.11

Singapore

On 10 August 2021 Singapore has issued Transfer Pricing Guidelines12 which provides guidance on the various aspects of transfer pricing. It specifies that TP documents should be prepared if guarantee fees paid/received by a taxpayer exceeds 1 million Singapore Dollar. The Guidelines does not prescribe any specific method or approach for the financial guarantee fees. It may be presumed that as Singapore normally follows OECD guidelines, to benchmark guarantee transactions the guidelines provided by the OECD would be followed by the tax authorities.

Transfer pricing approach regarding corporate guarantee in India and controversies

In India transfer pricing of payment and receipt of corporate guarantee has been a matter of controversies. Prior to 2012 as there was no explicit provision covering guarantee, it was argued by taxpayers that corporate guarantees were not in the nature of “international transactions” and hence outside the scope of transfer pricing regulations.

The Finance Act, 2012 introduced Explanation in section 92B of the Income-tax Act, 1961, clarifying that the expression “international transaction” includes “lending or guarantee”. This was necessitated to address the rulings where it was held that financial guarantees were not in the nature of international transaction and hence outside the scope of transfer pricing regulations. With introduction of the amendment mentioned above, this controversy stands resolved.

SBS Transpole Logistics Pvt. Ltd. (Delhi ITAT)

In a case, decided by the Delhi Bench of Income Tax Appellate Tribunal (ITAT)13 an Indian company had provided guarantee to enable a Singapore based branch of an Indian bank to lend working capital loan to its subsidiary in Singapore. In the TP Report it was stated that this transaction had no impact on the profits, income, loss or asset of either of the company on account of providing guarantee. This was not accepted by the Transfer Pricing Officer (TPO), who obtained rates of Bank Guarantee from various banks and then applied ad-hoc rate for making addition. Before the ITAT, the company initially argued that guarantee given by the company was not an international transaction as it did not impact profit, income, loss or asset of either of the company. However, subsequently this was not pursued. On the basis of several decisions,14 where guarantee of 0.5% was considered reasonable, it was argued that the rate adopted by the TPO was higher. The ITAT observed as follows:

“We find that there has been consistent view by various Benches of the Tribunal and Hon’ble Bombay High Court in the case of Everest Kanto Cylinders 58 taxmann.com 254 and Glenmark Pharmaceuticals Ltd. 43 taxmann.com 191 wherein 0.5% of the guarantee commission has been held to be at arm’s length. Accordingly, respectfully following the aforesaid decisions ……., we hold that the guarantee commission of 0.5% will be at arm’s length….”

Axis Clinicals Limited (Hyderabad ITAT) & Redington India (Madras High Court)

In another case, the Hyderabad Bench of the ITAT15 followed the decision of Madras high court16 where it was held that Explanation to Section 92B inserted vide the Finance Act, 2012 with retrospective effect from 01-04-2002 has settled the law that a corporate guarantee indeed forms an international transaction. So far as the quantification of the corporate guarantee is concerned the ITAT relied on the decision of the same Bench in another case17 and decided that the rate of the guarantee fees would be 0.6% (with a rider that it cannot be taken as benchmark in other cases).

It is important to observe that in India the determination of the arm’s length consideration has not been examined at any level in accordance with the process mentioned by the OECD and the approach has been ad hoc in nature based on estimation.

Conclusion

Financial transactions are integral and important part of any business organization. To expand operations as well as to add new ventures and activities companies borrow fund. However, many a times lenders insist for guarantee from a third party. The OECD observes that a financial guarantee provides for the guarantor to meet specified financial obligations in the event of a failure to do so by the guaranteed party. This provides benefits to the borrower as well as the lender. In multinational set up one company, with higher credit worthiness, provides the required guarantee for the benefit of another company of the group. The transfer pricing aspect of this transaction has drawn attention of the tax authorities in many countries. Unfortunately, there are no clear and detailed guidelines issued by tax authorities. Hence, one should use the guidance by the OECD.

To determine the arm’s length price of a financial guarantee fees it is imperative that proper study of the entities, nature of the transaction and the impact on the entities should be carried out as outlined by the OECD. In India a study of the decisions by various Benches of ITAT and High Courts lead to infer that corporate guarantee fees of 0.5% is considered adequate. However, this conclusion is, at most, the second best solution. It would be better if taxpayers and tax administration carry out detailed analysis of all aspects of the transaction for arriving at the arm’s length price. Maintenance of detailed documentation by taxpayer would enable it to justify the process of determination of the arm’s length price and enable it to avoid penalty.

References & Footnotes

  1. “The Advantage of Using Debt as Capital Structure” by Jay Way, updated January 28, 2019, https://smallbusiness.chron.com/ (accessed in June 2022)
  2. OECD 2022, Chapter X, paragraph 10.186
  3. “Difference Between Bank Guarantee and Corporate Guarantee” by Piyush Yadav, January 20, 2022, https://askanydifference.com/difference-between-bank-guarantee-and-corporate-guarantee/ (accessed in May 2022)
  4. https://www.lawinsider.com/dictionary
  5. https://corporatefinanceinstitute.com/resources/knowledge/finance/guarantee (accessed in June 2022)
  6. Para 10.158, Chapter X (Page 434), OECD Transfer Pricing Guidelines, 2022 (hereinafter referred to as OECD 2022)
  7. Para 10.165, page 436, ibid
  8. This section depends extensively on this chapter.
  9. Para 10.171, page 438, ibid
  10. “United States - Transfer Pricing Analysis – Guarantees” by Radhi Iyer; 2021 IJCRT | Volume 9, Issue 6 June 2021 | ISSN: 2320-2882; www.ijcrt.org (accessed in June 2022)
  11. “Transfer pricing of financial transactions – New OECD guidance: What will it mean for Australian taxpayers?” 10 March 2020; Natalya Marenina, https://www.bdo.com.au/ (accessed in June 2022)
  12. IRAS e-Tax Guide Transfer Pricing Guidelines (Sixth Edition); 10 August 2021, Published by Inland Revenue Authority of Singapore
  13. SBS Transpole Logistics Pvt. Ltd. Vs. ACIT, ITA No. 6166/Del./2017, Dated 06.05.2022
  14. Decisions referred included Dabur India Ltd, [TS-82-ITAT-2021 (Del)-TP (0.30%)], Manugraph India Ltd [TS-113-ITAT-2015 (MUM) -TP (0.50%)], Asia Paints Ltd, [TS-297-ITAT-2013(MUM)-TP) (0.20%)] (upheld by Mum High Court); Thomas Cook (India) Ltd, [69 taxmann.com 443(MUM Tribunal) (0.50%)]
  15. Axis Clinicals Limited [TS-717-ITAT-2021(HYD)-TP] dated 20.12.2021
  16. Pr.CIT Vs. M/s.Redington (India) Limited, dt.10-12-2020 Tax Case Appeal Nos.590 & 591 of 2019
  17. ITA No.1950/Hyd/2017 in Rain Industries Limited Vs. DCIT decided on 24.08.2021