Transfer pricing of intra-group financial guarantees
In general, 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. From the perspective of transfer pricing, analyses are directed towards the guarantees that constitute a legally binding commitment on the guarantor’s part. Because of such a commitment, the guarantor assumes a specified obligation of the guaranteed party if the latter defaults on its obligation. For instance, a financial transaction within an MNE group may consist of the parent company giving a guarantee to its subsidiary that takes out a loan from an unrelated lender.
When aiming for an accurate delineation of financial guarantees from a transfer pricing perspective, it is essential to gain understanding of the characteristics and scope of the guaranteed obligations and the impact of the guarantee commitment for all parties involved. When aiming to evaluate the arm’s length pricing, it is also important to describe the financial transaction precisely and enclose that description with the company’s transfer pricing documentation.
A financial guarantee transfers risks from one party to another
From the lender’s perspective, the overall exposure to risk is reduced by virtue of a guarantee. The lender now has access to the assets of one or several group companies in the MNE group if the guaranteed borrower company fails to meet its obligations. Effectively, this may mean that the lender takes into account the creditworthiness of the guarantor when making an assessment of the risk related to the borrowing. This can then improve the borrower company’s position.
The impact of a guarantee can be to permit a borrower to pay less for their debt, or to borrow a greater amount of debt, than it could in the absence of the guarantee. When evaluating whether the guarantee constitutes an arm’s length transaction inside an MNE group, the perspectives of both the guarantor and the borrower company receiving the guarantee must be kept in mind. The guarantor would not agree to enter into a guarantee commitment without getting an arm’s length compensation for the resulting exposure to risk. On the other hand, the guaranteed party would not agree to pay out a compensation higher than the benefits resulting from the guarantee.
Arm's length pricing of intra-group guarantees
Where the impact of an intra-group guarantee is to reduce the cost of financing for the borrower company, it might be prepared to pay for that guarantee, provided it was in no worse a position overall. The perspective of the borrower company is examined by comparing the borrower’s financing costs that would be payable if no guarantee were provided with the situation where the borrower has received a guarantee commitment. When evaluating the borrower company’s benefits, it is important to consider the benefit resulting solely from its MNE group membership – the “implicit support” – that the lender would take into account even if the borrower had not received any legally binding guarantee.
In the same way as in any other transfer pricing case, the evaluation must cover all the facts and circumstances specific to the intra-group situation under review. Sometimes, after a situation has been analysed, the conclusion may be that an existing guarantee commitment does not yield any additional benefit to the borrower company other than the benefit resulting from group membership. Also this possibility should be considered when evaluating whether transfer pricing is arm’s length.
An arm's length guarantee fee can be determined by several different methods depending on the circumstances of the case. The arm's length pricing may be determined e.g. with yield or cost based methods.
The yield method looks into the cash benefit that the guaranteed party receives from the guarantee in terms of lower interest rates. The cost approach focuses on the additional risk borne by the guarantor. First, the additional risk is quantified. Then, a minimum fee for the compensation can be defined, i.e. a minimum compensation that an unrelated guarantor would accept for the risk it takes.
More information on the methods is available in the OECD Guidelines.
Read more in the OECD’s Transfer Pricing Guidance on Financial Transactions.