In February 2020, the OECD published the final version of the Transfer Pricing Guidelines on Financial Transactions (OECD Guidance). Ever since, tax authorities are scrutinizing financial transactions and especially guarantees and implicit guarantees. Therefore, it is crucial to understand how implicit support works and how it impacts your transfer prices.
What is an implicit support?
The conditions of financing provided by third parties to a controlled entity (CE) can be impacted by the mere fact that it is part of a bigger group or multinational enterprise (MNE). Out of all these impacts the one that is in our focus is the potential financial support that an CE (the borrower) may receive from the group to meet its financial obligations should it face financial difficulties. This implicit group support or implicit guarantee may have a positive uplifting effect on the standalone credit rating of the CE which can lead to lower financing costs (interest) or improve the CE’s borrowing ability.
As a CE may receive such incidental benefit as a consequence of its group affiliation, such implicit guarantee does not require any payment in return. Then why it is interesting from a transfer pricing point of view?
How does implicit support impact your transfer prices?
Since implicit group support improves the CE’s credit rating, it decreases its cost of financing regardless if it is related-party or external financing (note that lenders within the group should act as any third-party lender. As third-party lenders are aware of the group affiliation and as a consequence might factor this in when determining the interest rate for the loan, related parties should do the same.)
An improved credit rating can have other implications as well. Guarantees are typically priced by considering its benefit brought to the borrower (yield approach). If the CE’s rating improves due to the implicit support, an explicit guarantee may have only a marginal impact on its borrowing conditions or it may even be deemed to be redundant as the explicit guarantee does not further improve the CE’s rating. Should this be the case one may risk of overcharging borrowers by disregarding the group support.
How can you define the level of the implicit group support?
The level of implicit group support highly depends on the relative status of an entity within the group. Entities whose role is more important for a group are more likely to receive group support than the ones whose link to the group is weak or whose activity is considered less critical for the group’s overall strategy.
Core entities, which are typically executing functions that are critical for the existence of the group (e.g. main operating entity hosting senior management and strategic leadership or holders of critical patents, IPs) can likely expect strong support from the group when facing financial difficulties, hence their rating will be closely aligned with group rating.
Strategic entities (such as holders of key infrastructures that enable market entrance e.g. port facilities) can also expect significant group support as the bankruptcy of these entities could considerably hamper the group strategy. The level of this support will, however, lag behind the one for core entities.
Other entities, such as tollers or distributors may expect only limited group support in case of financial difficulties, hence their credit rating will remain unchanged or relatively close to the stand-alone credit rating.
What can you do?
To be compliant with the OECD guidance on financial transactions, taxpayers should consider the key action points below:
- Define a process of how to assess the importance of entities within your group and what uplift is expected if they fall in one or the other categories described above
- Take inventory of guarantees and intercompany loans whose pricing may get impacted by implicit group support
- Assess the impact of implicit group support in line with your policy and retain documentation and calculations in support of your transfer prices.