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Pricing financial transaction #3: Defending guarantee arrangements

The most important question in transfer pricing (TP) is whether related companies are transacting with each other in the same manner as a transaction made between unrelated companies under comparable circumstances, i.e. whether or not the transaction can be regarded at ‘arm's length’.[1]

As highlighted in the two previous financial services transfer pricing (FSTP) articles (1. cash pooling controversies and 2. realistically available alternatives), various factors must be considered when determining whether a transaction conforms with the arm's length principle. These factors range from the functions performed, risks assumed and assets employed by the transacting parties to whether such an arrangement is the best realistically available alternative for economic benefits.[2]

In this FSTP article, we’ll explore intra-group financial guarantees through another real-world case in an OECD country, along with the controversy around deductibility.

What’s a financial guarantee?

Within multinational enterprise groups (MNE Group), it’s common for one entity (the guarantor) to provide a ‘financial guarantee’ for another entity (the guaranteed party) to meet specified financial obligations or reduce the Group’s funding costs. A financial guarantee is a legally binding commitment in which the guarantor assumes specified obligations in the event that the guaranteed party defaults on the obligation.[3]

There are various approaches to determining a guarantee fee. In the TP context, the selection of the most appropriate method should be consistent with the actual transaction which accurately reflects the functional profiles of both the guarantor and the guaranteed party.[4] As financial guarantees usually occur between related parties (and rarely under independent arrangements), pricing of guarantee fees can be challenging but not impossible. Often, a cost-benefit analysis is used to price the financial guarantee, where the costs of a guarantee should, in no case, outweigh the benefits.

For third party dealings, an independent guarantee (or guaranteed party) only pays guarantee fees to an independent guarantor (or financial institution) if the guaranteed party derives economic benefits from paying such fees. A financial guarantee usually provides economic benefits such as improved borrowing costs and terms (due to improved credit rating) or access to larger sums of capital, to name a few[5].

Under no circumstances would the guaranteed party incur expenses related to financial guarantees (to an independent party) if such an arrangement did not result in commercial and economic benefits. A similar concept would also apply to the payment of ‘excessive’ guarantee fees, where benefits derived by the payer can only be partially justified.

The court case General Electric Capital Canada Inc. versus Canadian tax authorities (2010) [6] explored below is a notable one that clearly illustrates the controversy around the deductibility of guarantee fees.

General Electric Capital Canada Inc. vs Canadian tax authorities (2010)

General Electric Capital Canada (GECC), rated B+/BB- by S&P, was a wholly-owned subsidiary of General Electric Capital United States (GEUS) operating under GE Group. GECC financed a substantial portion of its business with (third-party) debt in the form of a commercial paper. GEUS, rated AAA, had been charging a guarantee fee equivalent to 1% of the principal amount.

The Canadian tax authorities viewed this arrangement from the lens of the guaranteed party and attempted to fully disallow the payment of financial guarantee fees paid by GECC to GEUS. The tax authorities argued that by being a member of GE Group, GECC already received implicit support from GEUS, resulting in its credit rating being notched up. As the implicit support had already reduced its funding costs, the tax authorities viewed that the guarantee gave no additional benefits to GECC.

GECC appealed against the tax authority's position, arguing that the implicit support received from being a member of the GE Group only pushed its standalone credit rating from B+/BB- to BBB-/BB+. Had GECC not obtained a financial guarantee from its AAA-rated parent, its borrowing costs would have been much higher. GECC also defended the arm’s length nature of its pricing (1% on principal amount), arguing that total funding costs, including the guarantee fee paid to GEUS, were lower than the borrowing costs it would have obtained solely from an external financial institution with implicit support, and without the financial guarantee of GEUS.

The Canadian Federal Court of Appeals ruled in GECC's favour, concluding that the reduction in GECC’s funding costs was due to the financial guarantee that GEUS (an AAA-rated company) provided. The justification for the quantum of charge was also accepted, resulting in the 1% guarantee fee being ruled as being at arm’s length, and allowed as a tax-deductible expense.

From this case, we observe that the guarantee payment could be fully or partially disallowed if the taxpayer cannot justify the extra benefits beyond the implicit support that the guaranteed party has already received as a member of the Group. One of the main reasons that helped GECC win the case was its TP policy and proper supporting documents that successfully helped justify the arm’s length nature of the guarantee fee and convince the court of the extra benefits received.

Thailand’s TP landscape

Although Thailand is not an OECD member, there have been precedent cases in which the Thai Revenue Department (RD) had assessed taxpayers' intra-group financial guarantee arrangements, as well as various tax rulings on the RD’s position on certain aspects of the guarantee arrangements, both from the perspective of the guaranteed party as well as the guarantor.

With regards to the deductibility of guarantee fees, although the concept of implicit support has not been clearly mentioned, it is observed that tax deductibility would be allowed for the guaranteed party in cases where the taxpayer could substantially prove that there was a specific need, for example, to fulfil certain terms required by financial institutions, provided that the guarantee fee amount was appropriately charged according to the benefits received.

Similar to the landscape in OECD countries, the burden of proof on the arm’s length nature of the guarantee fee lies with the taxpayer, whereby the guaranteed party may resort to alternative measures (e.g. cost-benefit analysis, exploring realistically available alternatives) when dealing with revenue officers, taking into account the implicit support it already receives from being an MNE Group member. The remuneration of the guarantor should also not be overlooked, whereby any benefit (that the guarantor is providing to the guaranteed party) over and above the portion of the Group’s implicit support should be charged out. Accordingly, there is a need for a holistic and balanced approach to pricing guarantee fees from the perspective of the guarantor and the guaranteed party.

With precedent cases and robust developments in Thai TP laws and regulations in recent years, the RD will likely become more vigorous in assessing intra-group financial transactions.

Companies involved in intra-group financial transactions are strongly recommended to revisit their TP policies, where necessary, maintain supporting documents and keep up with the constantly changing laws and regulations to efficiently manage and mitigate their tax risks.

Source

[1] Paragraph 1.33, OECD Transfer Pricing Guidelines (Revised 2022)

[2] Paragraph 1.38, OECD Transfer Pricing Guidelines (Revised 2022)

[3] Paragraph 10.155, OECD Transfer Pricing Guidelines (Revised 2022)

[4] Paragraph 10.169, OECD Transfer Pricing Guidelines (Revised 2022)

[5] Paragraph 10.156-10.161, OECD Transfer Pricing Guidelines (Revised 2022)

[6] https://tpcases.com/canada-vs-general-electric-capital-november-2010/

Authors:

  1. Nopajaree Wattananukit
    Associate Partner, Tax and Legal 

  2. Vasoontaree Chanyatipsakul
    Senior Manager, Tax and Legal

  3. Chanidapha Orachorn
    Associate, Tax and Legal 

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