Financial guarantees in focus Financial guarantees in focus

Lately, the SFTA has been scrutinizing financial guarantees. It looks at any lack of guarantee fee payments for explicit financial guarantees. This could constitute a hidden dividend distribution, which would entail withholding taxes. It is therefore essential to track and document these types of transactions even in cases where no fee is due.

An explicit financial guarantee is an agreement, where the guarantor undertakes to meet specified financial obligations in the event of a failure to do so by the guaranteed party. The most frequently encountered situation in a transfer pricing context is where a Group entity (guarantor) provides a guarantee on a loan taken out by another Group entity (guaranteed entity) from a third-party lender.

This type of guarantee is different from the implicit guarantee, whereby group affiliation might result in an uplift of the stand-alone credit rating. Although the latter doesn’t require remuneration, implicit support needs to be taken into account when pricing financial guarantees. 

An explicit financial guarantee generally affects the terms and conditions of a borrowing. The additional financial power of the guarantor ultimately leads to a credit rating enhancement of the guaranteed entity. This credit rating enhancement can then lead to various benefits, such as lower interest rate or a greater amount of money to borrow. When determining the level of such credit rating enhancement one should take into account and eliminate the impact of the implicit support a Group entity receives just for being part of the MNE Group.

Considering that such financial guarantee constitutes a benefit to the borrower and an increased risk for the guarantor, it is subject to an arms’ length remuneration (guarantee fee) which should be priced in accordance with the OECD guidelines.

When a financial guarantee only increases the guaranteed party’s borrowing capacity, the loan might have to be delineated as a loan from the lender to the guarantor (followed by an equity contribution from the guarantor to the borrower) and would then be considered to be a shareholder guarantee. In other words, such guarantee is given by the guarantor solely in its shareholder capacity and is thus treated as a “shareholder activity” rather than a service, and in turn does not require any guarantee fee charge.

When the guarantee acts to allow the borrower to obtain better terms and conditions and to reduce the interest rate on the debt, i.e. the guarantee provides financial benefit to the guaranteed party, such guarantee should be remunerated by an arm’s length guarantee fee. 

Based on the latest OECD Guidance on financial guarantees, several methods can be used in order to determine an arm’s length guarantee fee.

• The Comparable Uncontrolled Price (CUP) method could theoretically be applied. Given, however, the limited, publicly available independent party guarantees, the CUP method is typically not used to price guarantees.
• The yield approach defines the maximum guarantee fee payable from the borrower’s point of view by calculating the interest rate differential between the actual interest paid and the interest that would have been paid based on the stand-alone credit rating (after taking into account implicit support) of the guaranteed party. This is the most common and generally accepted method to determine the maximum value for guarantee fees. 
• The cost approach which defines the minimum return to be received from the guarantor’s perspective by determining the expected loss at default or by determining the expected cost of additional capital required to support the risks assumed by the guarantor. 
• The valuation of expected loss approach considers a probability of default as well as the expected recovery rate in the event of default. Similarly to the cost approach, it provides the minimum return to be received from the guarantor’s perspective.
• The capital support method identifies the expected return on the additional notional capital required to bring the borrower up to the credit rating of the guarantor. 

To be compliant with the OECD guidance on financial transactions with regard to financial guarantees, taxpayers should consider the following key action points:

• Take inventory of guarantees in place and identify the legally binding guarantees that provide a benefit to the guaranteed party and require a guarantee fee charge.
• Ensure that TP documentation is available for each guarantee in place, even in cases where such guarantee does not require a guarantee fee charge.
• Establish a process/ approach for pricing and documenting guarantee fees.