Switzerland: Arm’s length price and transfer pricing implications of financial guarantees

The Swiss federal tax authority has increasingly initiated tax audits in relation to financial guarantees, and has been scrutinizing financial guarantees by looking at any lack of guarantee fee payments for “explicit financial guarantees.”

The evaluation of financial guarantees concerns whether they constitute a hidden dividend distribution that would have withholding tax and transfer pricing implications. 

An explicit financial guarantee is an agreement whereby 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 when 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 affiliations 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 a credit rating enhancement, there must be taken into account (and eliminate) the effect of the implicit support a group entity receives just for being part of the multinational enterprise (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 arm’s length remuneration (guarantee fee) that is to 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 then considered a shareholder guarantee. In other words, such guarantee would be given by the guarantor solely in its shareholder capacity and thus would be 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 is to be remunerated by an arm’s length guarantee fee. 

Based on the latest Organisation for Economic Cooperation and Development (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. However, given 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 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. Similar 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 may need to 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
• Make transfer pricing documentation available for each guarantee in place, even in cases when such guarantee does not require a guarantee fee charge
• Establish a process and approach for pricing and documenting guarantee fees

Read a September 2021 report prepared by the KPMG member firm in Switzerland