KPMG report: Implicit guarantees in transfer pricing

The OECD in February 2020 published the final version of the transfer pricing guidelines on financial transactions. 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 affects transfer prices.

The conditions of financing provided by third parties to a controlled entity can be affected by the mere fact that it is part of a bigger group or multinational enterprise (MNE). Out of all these effects the one that is in tax professionals’ focus is the potential financial support that a controlled entity (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 controlled entity that can lead to lower financing costs (interest) or improve the controlled entity’s borrowing ability. 

As a controlled entity may receive such incidental benefit because 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?

Since implicit group support improves the controlled entity’s credit rating, it decreases its cost of financing regardless if it is related-party or external financing. 

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 controlled entity’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 controlled entity’s rating. Should this be the case, one may risk overcharging borrowers by disregarding the group support.  

The level of implicit group support highly depends on the relative status of an entity within the group. Entities with a role that is more important for a group are more likely to receive group support than the ones with a weak link to the group or with an activity that 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.

To be compliant with the OECD guidance on financial transactions, taxpayers may want to consider certain key action points:

• Define a process of how to assess the importance of entities within a group and what uplift is expected if they fall in one or the other categories described above
• Take inventory of guarantees and intercompany loans with pricing that may get affected by implicit group support
• Assess the effect of implicit group support in line with policy and retain documentation and calculations in support of transfer prices

Read a January 2022 report prepared by the KPMG member firm in Switzerland