Interest imputation: transfer pricing the lender: implicit and explicit loan guarantees
There are three aspects to guarantees for financial transfer pricing, and they easily become confused:
- For thin cap purposes
When considering borrowing capacity from a lender’s perspective guarantees should not be taken into account; TIOPA10/S152(5) applies.
- Transfer pricing of guarantees
Guarantees are subject to transfer pricing in themselves, when the issue is what if anything should be charged at arm’s length for a guarantee. These may be intra-group, but they might be third party. This issue is what advantage, if any, the guarantee gives the borrower which it cannot obtain on a stand-alone basis, and what that is worth.
- Guarantees for compensating adjustment purposes
Guarantees are important as a mechanism for reducing double taxation when there is a thin cap disallowance. Where a guarantor can show that it has the borrowing capacity to take on part of the debt which gave rise to the disallowance, it may claim a compensating adjustment. This takes the form of an interest deduction relating to whatever part of the borrower’s debt the claimant demonstrates that it can take upon itself. These are likely to arise from implicit guarantees between UK resident members of the same group. See INTM542130 for more detail.
Implicit and explicit loan guarantees
Guarantees (as per 2. above) may be subject to transfer-pricing, since they are a business facility, to test whether they improve the terms on which the recipient can borrow. A genuine guarantee is a provision for which a charge can be justified at arm’s length, usually in the form of a fee. It represents the use of another party’s credit rating, which can be a very valuable commodity, transferring risk to the guarantor, and possibly reducing the guarantor’s own ability to borrow and/or their cost of borrowing. The actual significance of a guarantee will vary from case to case, from being just an additional “belt and braces” formality which the lender prefers to have but which does not materially affect the cost of borrowing, to a commitment without which the loan might not have been made at all.
If a guarantee is only implicit, the lender will not be able to sue the guarantor in the event that the borrower defaults on a loan. The guarantor may not have taken on a risk to which a price can be attached. Even a comfort letter from the UK parent may not be sufficient to create a measurable guarantee, unless it binds the issuer in the event of its subsidiary’s default. Expectation in such circumstances may count for as much as a legally binding commitment.
Seeking to impute a fee in relation to the effect simple membership of a group is inappropriate, a conclusion supported by the OECD Transfer Pricing Guidelines (at para 7.13). This gives an example which observes that “passive association should be distinguished from active promotion of the MNE group’s attributes”. It says:
“no service would be received where an associated enterprise by reason of its 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, or where the enterprise benefited from the group’s reputation deriving from global marketing and public relations campaigns.”
It may come down to what evidence there is that the guarantor will make good its implicit guarantee. It may have a track record of supporting or abandoning subsidiaries which get in trouble; it may have a reputation for defending its name and standing by its subsidiaries. A lender is not going to set much store by an unenforceable “letter of comfort” unless it can have confidence that the signatory keeps their word. It is a matter of weighing up the likelihood of an implicit guarantee being honoured and the effect that would have on the borrowing terms of the borrower.
The term “implicit guarantee” is also used in relation to the legislation at TIOPA10/S192 (the former ICTA88/SCH28AA Para 6D) where companies may claim adjustments as guarantor in relation to interest disallowed on thin cap grounds. Where affiliated companies make such claims on the basis that a guarantee is implicit because of the relationship between the thinly-capitalised and the claimant company, that should not of itself be taken as evidence of the existence of an actual guarantee that requires pricing. See INTM542130 onwards for more information.
If there is an explicit guarantee, which has been confirmed as providing a benefit to the borrower after taking into account any implicit support, and for which the reward for that benefit is below the arm’s length price (or nil), then, under OECD Guidelines, a fee may be imputed.
The size of the guarantee fee depends on the value of that guarantee to the borrowing party. This is often calculated as a percentage of the principal concerned. It is advisable to calculate roughly the possible yield which could be achieved by imputing a fee before becoming too embroiled in a case.
There is an argument that the arm’s length fee for an explicit guarantee should be reduced if it is found that the borrower already has the benefit of implicit guarantees. It will not be easy valuing the extent of an implicit guarantee, but to charge for the explicit guarantee without taking account of implicit support could be regarded as charging for something that was, to some extent at least, already in place. This is the line taken in the Canadian case, GE Capital Canada Inc. v. Her Majesty the Queen, 2009DTC563.