Raising loan funding at the start up phase of a business can be very challenging.
At times, where the borrower is part of a group, then financial institutions may make any loan funding contingent on a guarantee from a related party.
But whilst this might help unlock financing, it can create potential tax pitfalls.
What do we mean by a financial guarantee in this context? Well, in essence it is a legal promise made by a party (guarantor) to another party (bank/creditor) to cover a borrower’s debt in the case of the borrower defaulting on its obligations.
The lender obtains advantageous conditions, either lower interest rates, better terms and conditions or a higher credit limit i.e. simply “piggybacking” on the guarantee provided by the guarantor.
Whilst most professionals understand the need for setting an appropriate interest rate on an intra-group loan from both a financial and tax perspective, most of the times guarantee fees are not considered.
In addition, different considerations apply depending on whether a financial guarantee is explicit or implicit.
For an explicit guarantee, there is no doubt that the lender enjoys an economic benefit and should therefore be charged.
Economic benefits will be determined by several factors such as whether the lender was able to borrow at a lower interest rate or benefit from less stringent covenants, borrow at all, or more than it would on a stand alone basis.
This view was upheld in the famous Canada vs. General Electric Capital case heard in November 2010, and is supported by Base Erosion and Profit Shifting (BEPS) Action 8-10 (ensuring transfer pricing outcomes align with the value created).
Accordingly, where there is an explicit guarantee fee, tax authorities for both the guarantor and the lender will be interested to determine whether the guarantee fee charged is at arm’s length.
By contrast no charge should be made for implicit guarantees.
This position is set out in the Organisation for Economic Co-operation and Development (OECD) Guidelines (2017) which confirm that there should not be any charge for an implicit guarantee that an entity gets by simply being part of the group.
This position was also upheld in the Chevron Australia Holdings Pty Ltd case decided in 2017.
So if you establish that there is an explicit financial guarantee, the next step is to determine the arm’s length guarantee fee.
In the absence of internal comparables, the so called “yield approach” can be used to arrive at the maximum potential interest rate savings achieved by the borrowing entity because of the guarantee.
This approach calculates the spread between (i) interest rate that would have been payable by the borrower without the guarantee; and (ii) interest rate payable with the guarantee in place. The difference can then be used to test/ set up the guarantee fee charged by the related party guarantor.
Given the transfer pricing risks associated with financial guarantee arrangements, tax practitioners within organisations should (i) liaise with treasury and legal departments to review in detail loan offer letters from banks to check whether a guarantee has been used to determine the terms of the offer; (ii) consider the arm’s length nature of the financial guarantee; and (iii) in the event of an explicit guarantee, assess the tax implications, especially from a withholding and corporate income tax perspective.
The concern is to ensure alignment of treatment of a guarantee fee in the jurisdiction of the borrower and the guarantor; otherwise, the risk is that the fee is taxed in full on the guarantor, but without full deduction being given to the borrower for this cost - so potentially leading to double taxation.
Omari Nina is PwC Senior Associate - Tax Services. The views expressed do not necessarily represent those of PwC