Upstream guarantees from a German transfer pricing perspective

Banks that grant loans to multinational enterprises (MNEs) or a parent company based in a foreign country may require subsidiaries of the parent company to provide collateral. This may include, for example, the pledging of assets or the assumption of joint and several liability for the loan. As these guarantees are directed upwards from the subsidiaries to the shareholder, such guarantees are typically referred to as "upstream guarantees".

The corresponding consideration for the security provided by the subsidiary, if required, is the transfer price, the value or amount of which must be at arm's length. The taxpayer must be able to document why the guarantee fee paid is arm's length or justify why no guarantee fee is charged.

The German tax authorities regularly scrutinise cross-border financial transactions. MNEs are therefore well advised to review the arm's length nature of the guarantee agreement in order to minimise transfer pricing risks. This article describes the German transfer pricing perspective on upstream guarantees with reference to the so-called German Administrative Principles on Transfer Pricing (2024) ("VG VP"), which are binding for the German tax authorities ("DTAs"). As the OECD Transfer Pricing Guidelines (2022) ("OECD TP Guidelines") are attached to the TP Guidelines, the OECD TP Guidelines must also be taken into account from a German perspective.

An arm's length analysis of an upstream guarantee fee in the context of a secured loan (often a senior secured credit facility) provided by a bank (often a syndicate of banks) generally considers two separate issues, namely reasonableness in principle ("Is a guarantee fee required?") and reasonableness in amount ("What is a reasonable fee?").

Transfer pricing analysis on the merits:

First, the reasonableness on the merits is generally assessed based on the German and OECD transfer pricing guidelines through a benefit test, i.e. whether the guarantee provided by the German guarantor, typically one of many guarantors, to the parent company (the original guarantee beneficiary) represents a real benefit to the parent company. The main benefit theoretically consists of improved creditworthiness for the borrowing shareholder, which is the beneficiary affiliated company, while the bank can also be regarded as the beneficiary.

The view of the German tax authorities on this topic is summarised in the VG VP (margin no. 3.150, ibid.):

"For the advantages of a proven increased creditworthiness of a company, a transfer price corresponding to the arm's length principle is to be applied. The advantages can result from the fact that at least one member of the multinational group of companies assumes the obligation towards a third party to secure the company's payment obligations. This can take the form of a guarantee, a surety, a loan agreement, a hard letter of comfort or real collateral. A transfer price is only to be recognised if the obligor assumes an actual risk position (...)"

As outlined above, the German view needs to be analysed in conjunction with the OECD VPRL, which proposes the following key criteria for such an analysis [emphasis added by the authors]:

• "(...) A guarantee (...) (is) a legally binding commitment on the part of the guarantor (...) to honour a specific credit obligation of the guaranteed party if the latter defaults on that obligation." (para. 10.155, OECD VPRL).
• "In order to properly distinguish between financial guarantees, it is first necessary to analyse the economic benefit they provide to the borrower in addition to the benefits arising from the passive link (...)." (para. 10.156, OECD VPRL).
• "By providing an explicit guarantee, the guarantor is exposed to additional risk, as it is legally obliged to pay if the borrower defaults." (para. 10.163, OECD VPRL).

Economic advantages (see second point above) can be understood, for example, as an improvement in the loan conditions, in particular the interest rate, or as access to a larger loan amount.

In a typical case, an assessment should be made as to whether the implied credit rating of the loan transaction (of an unrelated third party) is improved by the collateral and, as a result, the interest rate is lowered. In addition, it must be analysed why a prudent and conscientious manager of the guarantor would have granted a guarantee (to an unrelated third party) without compensation. Is a compensation for the parties intended by the guarantor receiving intercompany debt and the guarantee being taken into account in the interest rate of the intercompany loan?

The above key criteria should therefore be considered when analysing whether an uncompensated upstream guarantee can be recognised on its merits.

Transfer pricing analysis by amount:

Second, if the foregoing analysis confirms the existence of a benefit or enhanced creditworthiness on the merits, the guarantor should be compensated by a guarantee fee payable by the borrowing shareholder. The final guarantee fee is usually a product of various factors:

• Guarantee valuation basis
• Guarantee fee rate (p.a.)
• Allocation key (if several guarantors exist)
• Number of guarantee days actually provided in a year divided by 360 (or 365)

A key question is how the guarantee fee rate can be determined. In practice, for example, the rate can be determined conceptually using either the expected benefit method or the expected cost method or a combination of both, with the former representing a lower limit and the latter an upper limit. For example, the expected benefit method calculates the interest rate differential - the financial benefit - based on the difference in the issuers' ratings, where the latter is the difference between the borrower's rating without the guarantee provided by the guarantors and the borrower's rating after enhancement by said guarantee.

Assuming that no guarantee fee is charged, from a guarantor's perspective, the DPAs could question the absence of a guarantee fee in the course of a local audit if an economic benefit was granted to the foreign shareholder as the original debtor. Or if a guarantee fee is charged but the DPOs disagree with one of the parameters relevant to the calculation of the (absolute) guarantee fee, in particular the guarantee fee rate. The risk of an income adjustment is "multiplied" by the number of tax audit years and potentially also for subsequent years if the issue persists. However, in certain circumstances, the absence of a guarantee fee, which at first glance appears necessary, may still be considered reasonable and potentially defendable from a substantive arm's length perspective. However, this requires an in-depth analysis on a case-by-case basis.

In the transfer pricing context, proper documentation (including presentation of the facts, functional and risk analysis and economic analysis) is required from a German compliance perspective in accordance with Section 90 (3) of the German Fiscal Code (AO). It is also generally recommended to conclude a written intra-group agreement on the guarantee fee, especially if several guarantors are involved.

If no guarantee fee has been charged for financial years for which tax returns have already been filed and the company concludes - e.g. during a review or when preparing transfer pricing documentation - that a fee should have been charged, the company should immediately contact its tax or legal advisors to check whether a disclosure letter to the tax authorities may be necessary to protect management from personal consequences and the company from penalties.

German companies involved in upstream guarantee arrangements are therefore well advised to review the appropriateness of their transfer pricing position based on eligibility and/or amount to ensure that the correct income has been recognised in their tax returns and to avoid or mitigate audit risks.

Our KPMG transfer pricing experts will be happy to answer any questions you may have.

Publication date:

27.03.2025