The operating business of company groups is to a large extent financed by debt capital. The financing banks regularly require appropriate security. The ongoing financial crisis and the implementation of the Basel III rules coming into force in 2013 increase demand for better accessibility to guarantees. Whereas shares of the subsidiary company were considered sufficient security in the past, a guarantee from the subsidiary itself is also generally required now.
Transfer-pricing issues have arisen from the change of practice. In particular, it is unclear whether the parent company should pay a guarantee fee and if so, how to set the fee at arms-length.
Step One: Is the Provision of the Guarantee Subject to Transfer-Pricing Regulation?
According to generally accepted principles, cross-border related party transactions are to be carried out at arm’s length. To assess whether a particular transaction requires the payment of a fee, hidden distribution of profits and arm’s-length (i.e., at customary third-party prices) principles are applied.1
Generally, if an unrelated party would require payment for a guarantee provided under the same circumstances, failure to pay a fee to the subsidiary could indicate that there has been a prevented increase of assets, which is considered to be a hidden distribution of profit. However, all circumstances must be examined before reaching a conclusion because not all financial disadvantages automatically cause hidden distributions of profit. For example, there may exist advantages for the subsidiary (e.g., more favorable credit conditions) that compensate for the disadvantage. Also, before a hidden distribution of profits can be established, there would have to be a determination that the parent company benefited from joint liability with its subsidiary. This is commonly not the case since the parent generally will provide its shares in the subsidiary as a guarantee anyway (i.e., the quality, not the quantity of the guarantee is affected by the accession of the subsidiary).
Guarantee fees arising from cross-border transactions between related parties also must comply with the arm’s-length principle.2 Thus, it must be examined whether remuneration would be paid where an unrelated party would be providing a lender with easier access to a guarantee that has already been provided by the actual borrower (as opposed to providing a separate and independent guarantee to the lender).
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The arm’s-length principle has been found to be satisfied where interest on loans within a group of companies is not adapted to account for the absence of a guarantee (even though a guarantee would have been common between unrelated parties). This result has occurred where guarantees are granted within the framework of a “backup within the company group” (i.e., the relationship of the related parties per se provides a guarantee).3 If the arm’s-length principle is satisfied in the “backup” situation, one could argue that it also should be satisfied where a subsidiary guarantees a parent’s credit line without the payment of a guarantee fee (provided there are non-tax reasons for such an arrangement).
Step Two: How to Set the Arm’s-Length Fee?
Although there may be strong support for no payment of a guarantee fee, the German Tax Authorities have not yet ruled on this issue. Should it be the case that a fee should be charged, the difficult question of how to set an arm’s length price arises. Again all the facts must be examined. For example, some sources suggest a range from 1/4 percent to 1/8 percent of the volume of the credit might be an appropriate arm’s-length fee for guarantees by a subsidiary, however, no explanatory calculations are provided.4 Banks provide guarantees for a fee ranging between 1 percent and 3 percent of the volume of the credit, but this would not appear to be an appropriate comparison, because such an amount would reflect the circumstances of the bank rather than the subsidiary (e.g., strict regulatory requirements applicable to banks and costs associated with obtaining information which the subsidiary already has and risks related thereto).
Furthermore, the subsidiary’s specific facts and circumstances must be considered (e.g., its interest or/and conditions) and whether more than one subsidiary is guaranteeing the same credit line. The effects of these factors on the arm’s-length price, while difficult to calculate, should be examined.
Cash-Pooling Structures Also Affected
Modern cash-pooling structuring presents a case similar to bank loans in company groups. It is a common practice for banks to require security from subsidiaries with an indirect relationship to liabilities arising from a master account. Therefore, the same issues arise in this circumstance as well.
Even though the German Tax Authorities require application of the arm’s-length principle, there may be support for the non-payment of a guarantee fee, for example, where it can be established that there is no advantage to the parent company, the parent company may be able to support the position that its situation is analogous to the general backup in the company group situation.
If an arm’s-length fee were found to be necessary, there are many “corporate effects” that make it difficult to establish an appropriate arm’s-length fee. At least it could be argued that the fee should not be lower than costs incurred by the subsidiary through the guarantee risk, and not higher than interest savings for the parent borrower.
Since the topic will grow in importance, and there are no clear answers at this time, all financing structures will have to be examined case by case. The transfer-pricing rules are an essential part of this analysis.