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New challenges on pricing intragroup financial guarantees.

New challenges on pricing intragroup financial guarantees.

Following the Covid 19 outbreak, raising capital became more cumbersome. Multinational groups could use intragroup financial guarantees to decrease their cost of funding. New guidance has been published to price such guarantees at arm’s length conditions, increasing scrutiny by tax authorities.
Nicolas Gillet, EY Luxembourg Transfer Pricing Partner and  Chiara Palmieri, EY Luxembourg Manager Transaction Financial Engineering & Transfer Pricing
Nicolas Gillet, EY Luxembourg Transfer Pricing Partner and Chiara Palmieri, EY Luxembourg Manager Transaction Financial Engineering & Transfer Pricing
Photo credit: Ernst & Young Services SA
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The Covid 19 outbreak brought the global economy to a halt, thereby driving many companies out of business. In light of these current economic conditions, it may not be the easiest time to raise capital.

Nevertheless, to pursue new opportunities and to boost their liquidity, companies may need to borrow money from the market. When entities are part of a multinational group, it might be easier and cheaper, to borrow money if a financial guarantee from related parties is in place.

A guarantee is a promise made by one party (a guarantor) to another party (a bank) to cover the debt of a borrower in case the borrower defaults on its obligation. Effectively, such a guarantee may allow the borrower to borrow on the same (or equivalent) terms to those applicable to the guarantor.

In the context of intragroup guarantees, the following are the most common:

  • Downstream guarantee: the subsidiary receives a guarantee from the parent;
  •  Upstream guarantee: the parent receives a guarantee from the subsidiary;
  •   Cross guarantee: two or more related companies provide a guarantee to each other.

While guarantees are commonly used, not a lot of attention has been paid as to their pricing at market conditions (i.e. at arm’s length) mainly because they are difficult to price but also because the tax teams are not aware that a guarantee has been put in place.

However, the publication of the OECD Transfer Pricing Guidance on Financial Transactions to be included as Chapter X in the OECD transfer pricing guidance, (“Chapter X”), brings arm’s length pricing of intragroup guarantees to the forefront.

To consider any transfer pricing consequences, such as the payment of a guarantee fee, it is necessary to understand the nature and the extent of the obligation for all parties involved:

  1. Identification of the economic benefit created by the guarantee to the borrower, which can be estimated as enhancement of the terms of the borrowing or access to a larger amount of borrowing.
  2. Effect of group membership. Anything less than a legally binding commitment, such as a “letter of comfort” involves no explicit assumption of risk and therefore does not lead to a specific remuneration for the guarantee provided. It creates only a benefit by passive association between guarantor and borrower.
  3.  Financial capacity of the guarantor. A lender would benefit from the stronger (or equal) credit rating if the guarantee effectively allows the lender to access either wider recourses or to reduce the applicable interest rate.

Special consideration should be given to cross-guarantees, where two or more entities in a group guarantee each other’s obligations. The effect of a cross-guarantee for the borrower is that it has multiple guarantees on its borrowings and may stand as guarantor for multiple borrowings itself. This increases complexity not only because of a large number of guarantees but also due to the fact that each party could provide a guarantee and be guaranteed by the party for whom it is now acting as guarantor. An analysis of the facts related to the cross-guarantee may lead to the conclusion that such an arrangement does not enhance the credit rating of a group member beyond the level of passive association.

It is clear that following the publication of Chapter X, additional challenges will arise in pricing intragroup guarantees. Moreover, tax authorities are paying much more attention to this type of transaction and, therefore, further consideration should be given when putting them in place.