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HMRC internal manual

International Manual

Transfer pricing: the main thin capitalisation legislation: Guarantees - what they do and what they are

Nature and effect of guarantees in thin capitalisation

As explained in INTM413060, a provision may arise from a series of transactions rather than just a single transaction between two connected companies. A loan from a third party which is guaranteed by a connected person constitutes a provision consisting of a series of transactions. The same would apply to a loan from a connected party which is guaranteed by another connected party. The most common instance will be a single loan supported by a single guarantee but the provision could consist of any number and combinations of loans and cross guarantees.

The effect of a guarantee

Guarantees most commonly support third party borrowing, but can be used to support loans between group companies: for example, a European group treasury company might provide finance to a fellow group company resident in the UK, but under guarantee from the UK borrower’s parent company.

With the additional comfort offered to the lender by a guarantor, the lender might provide a loan on more advantageous terms than the borrower could have obtained otherwise, because the guarantee will reduce the risk to the lender. In the event of a failing borrower and no guarantee, a third party lender’s prospects of recovering its outlay would be at risk. However, with a guarantee in place, the lender should have greater and more immediate success in recovering debt and interest, simply by exercising its rights under the guarantee and seeking payment from the guarantors, than it would by waiting for a distribution of assets in a liquidation, or having to write off all or part of the loan. The guarantor would of course have to demonstrate that it could make good its pledge, and probably provide security in relation to its commitment.

The effect of a guarantee on loan terms is varied. Guarantees may help secure:

  • A larger loan
  • A lower rate of interest
  • An increase in duration
  • Less demanding covenants on the borrower

Any of these may have implications for the transfer pricing of the transaction e.g. a larger loan may be obtainable, but it may be more than the borrower would be able or willing to take on at arm’s length. Also, the guarantee may secure preferable terms as compared to what would be otherwise on offer. A lower interest rate on a larger amount of debt might be regarded as a more attractive and not a more expensive deal. See INTM413120.

The presence of a guarantee does not necessarily signify a change in lending terms, and in any case larger, longer, etc, do not mean “better” for the borrower; a larger loan may be more than the borrower would or could borrow without this help, and therefore more than the borrower could or would borrow at arm’s length. Lenders may seek guarantees as part of a “belt and braces” approach: not a crucial factor, but better to have than not have. A typical example being the cross guarantees required by lenders when they lend to a group of companies.

Definition of the term guarantee

The term “guarantee” is defined in TIOPA10/S154(4) (previously ICTA88/SCH28AA/PARA1A(7)). The definition is very wide, and includes a reference to:

  • a surety, and
  • any other relationship, arrangements, connection or understanding (whether formal or informal) such that the person making the loan to the issuing company has a reasonable expectation that in the event of default by the issuing company the person [the lender] will still be paid by, or out of the assets of, one or more companies.”

For many groups, honouring the debts of subsidiaries and wider affiliates is a matter of maintaining their own credit reputation: they will cover the debts of subsidiaries because they do not want to be associated with defaulting on debts, which might undermine the group’s credit rating and therefore its ability to raise finance in the future. Informal arrangements of this type will fall within the definition of guarantee in TIOPA10/S154(4), and would be termed “implicit guarantees”.

Implicit guarantees

The wide definition of guarantee in TIOPA10/S154 (4) recognises the possibility that whilst a guarantee may not be formally documented, the behaviour of the parties indicates that a guarantee exists.

Implicit guarantees are difficult to evaluate, since their terms are not explicitly stated and motivation may be mixed and obscure. A major multinational may wish to protect its own credit status and reputation by making good any debts which its subsidiaries are unable to meet, but is it difficult to discern whether that is primarily a service provided to the subsidiary, whether it arises from a policy aimed at protecting the MNE’s own credit rating, or a mixture of both.

An implicit guarantee is perhaps more likely to exist where the recipient has an important role within the group or shows a close identification with the name or brand of the group.

Para 7.13 of the OECD Transfer Pricing Guidelines says that

“…no service would be received where an associated enterprise by reason of affiliation alone has a credit rating higher than it would if it were unaffiliated, but an intra-group service would usually exist where the higher credit rating were due to a guarantee by another group member…”

The paragraph goes on to distinguish “passive association” from “active promotion”. In circumstances where mere affiliation of the borrower to its group provides comfort to a lender, and leads to an improved credit rating there is no guarantee and therefore a fee would not be charged at arms length. Where there are intra-group guarantees, explicit or implicit, the effect that the guarantee has on the terms of the loan need to be separated from any effect that can be attributed to passive association. The track record of the group in situations where a group member is in financial distress will be instructive.

The issues of whether and to what extent passive association improves a borrower’s credit rating and at what point group support becomes more than passive association are difficult and complex.

The treatment of guarantees for transfer pricing purposes is explored in INTM413120.