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HMRC internal manual

International Manual

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Transfer pricing: the main thin capitalisation legislation: Evaluating guarantees: establishing the arm’s length value of a guarantee

Establishing the arm’s length value of a guarantee

This is about guarantee fees and their worth to the borrower, where the borrower is actually charged for the provision of a guarantee. This is therefore about:

  • what value the guarantee brings to the borrower, compared to what it could and would obtain without it
  • What is the appropriate level for the guarantee fee which the borrower pays

S153 (Para 1B) first establishes the arm’s length price of the loan without guarantees. This does not necessarily mean that guarantees will be permanently ignored in pricing the debt. In considering what guarantee, if any, would have been provided at arm’s length. TIOPA10/S153(2) (PARA1B(2)) asks that “all factors” be taken into account in working this out, and particularly asks what would have happened in the absence of the special relationship between the borrower and the provider of the guarantee (i.e. at arm’s length):

  • would the guarantee have been provided at all
  • what amount would have been guaranteed
  • what consideration (fee, etc) and other terms would have been agreed

This is simply a matter of applying a transfer pricing test to guarantee costs.

At arm’s length, a company would not take on the extra cost of a guarantee unless that guarantee makes the overall cost of finance cheaper than it would be on a stand-alone basis. If the cost of the guarantee itself is greater than the saving it brings, it will be disallowed to the extent that it causes the total finance costs relating to the guaranteed debt to exceed the stand-alone arm’s length price.

When does a guarantee provide an arm’s length benefit?

The scenarios below set out how TIOPA10/S153 operates for the borrowing company. The “cost of loan” in the headings below refers to actual costs of borrowing excluding guarantee fees and not adjusted by transfer pricing provisions. These scenarios do not demonstrate the arm’s length price of a guarantee, but will show whether the guarantee has brought a benefit when the borrowing is considered on an arm’s length basis.

  1. Guarantee fee charged and cost of loan exceeds arm’s length

The borrower is already paying more than it would if borrowing on a separate entity basis. Considered at arm’s length, the value of the guarantee is nil and it simply represents an additional cost. The terms of the loan are adjusted for transfer pricing purposes to the arm’s length amount, the non-arm’s length element of the loan costs is disallowed, and the guarantee fee is disallowed.

There is no apparent benefit from this guarantee, so any claim that there is value meriting a guarantee fee should be subject to a thorough analysis to identify whether the guarantee provides any other, less obvious commercial benefit that would justify the payment of a fee. A guarantee might enable a borrower to spread its finance costs over a longer period, which might be advantageous in certain circumstances.

  1. Guarantee fee charged and cost of loan is equal to the arm’s length

The cost of the loan is arm’s length so no adjustment is required with respect to the loan itself, but as in 1 above, it would be difficult to justify a guarantee fee. It appears to provide no benefit by way of cheaper financing and is likely to be disallowed unless some less obvious benefit can be demonstrated.

  1. Guarantee fee charged and cost of loan is less than arm’s length

This situation may arise where the guarantee is taken into account in setting the terms of the loan. For example, the presence of the guarantee may have the effect of improving the credit rating of the borrower and achieve a lower interest rate. As the guarantee has reduced the cost of the loan to below the stand-alone cost, there is a clear benefit to the borrower in entering into the guarantee. It is therefore likely that at arm’s length a fee would be paid, as there is a genuine benefit to the borrower. However, the borrower would only agree to pay a fee at arm’s length if there was an overall saving, and the level of the fee should reflect this.

  1. No guarantee fee charged and cost of loan is less than arm’s length

Where there is a guarantee in place but no fees have been charged, the guarantee may still provide the borrower with beneficial terms, such as a reduced interest rate. The arm’s length cost of the loan will exceed the actual cost of the loan, because the guarantee reduces finance costs without itself costing anything. It might be argued that, at arm’s length, a fee would be charged for such an effective guarantee, but one cannot be imputed in the computations of the borrower, because transfer pricing legislation operates as a one way street. This scenario creates no tax advantage, so the basic transfer pricing conditions are absent. Of course if the guarantor negotiated a fee, that would be considered on its merits.

Evaluating the arm’s length value of a guarantee fee should be more than a simple mathematical comparison of actual and arm’s length costs. It is worth emphasising that all relevant factors should be considered:

  • the obligations of the guarantor
  • its ability to fulfil them
  • an analysis of the improvement to the borrower’s credit worthiness
  • consideration as to whether the guarantee brings the borrower something beyond the implicit parental or group support provided by passive association with fellow group members.

It may be that the benefits provided by a guarantee, particularly informal understandings, are such that a guarantee fee would not normally be justified. Furthermore, where the guarantor is unable to honour its commitments under the guarantee because of the state of its own finances, the guarantee will in practice have no value.