• A clear solution isn’t guaranteed: A practical transfer pricing discussion on financial guarantees

A clear solution isn’t guaranteed: A practical transfer pricing discussion on financial guarantees

01 October 2020

Marcus Stelloh , Head of Transfer Pricing |

In February 2020, the OECD published its much anticipated Transfer Pricing Guidance on Financial Transactions,  which is to be included in the OECD Transfer Pricing Guidelines as Chapter X. Until this point, multi-national enterprise (MNE) groups relied on the draft guidelines issued by the OECD in July 2018, which left the door open for different interpretations.

When it comes to financial guarantees, Chapter X is, in theoretical terms, clear on how to delineate a guarantee but is thin on the practical valuation and corresponding pricing thereof.

Before diving into the technicalities, it is prudent to confirm what we mean by a “financial guarantee.” When considering funding arrangements from a third party lender’s perspective a bank or financial institution may require a guarantee where a borrower has a sub-investment grade standalone credit rating or a more flimsy balance sheet which could result in a borrower struggling to obtain financing or being charged a higher than expected interest rate for a financial arrangement. To address this issue, a MNE group, typically a specific treasury entity or an entity responsible for the group’s treasury function, may step in as a guarantor and agree to meet specified financial obligations in the event of a failure to do so by the borrower. From a transfer pricing perspective, we need to delineate the transaction and determine what benefit, if any, is transferred by the guarantor to the borrower.

The accurate delineation of a financial guarantee may result in various conclusions. For example, it may be determined that the guarantee allows the borrower to obtain a larger amount of funds, or allows the borrower to obtain a more favourable interest rate. The outcome may also be that the guarantee is not beneficial to the borrower beyond that which arises from being part of a MNE group. In this article, we begin from the point at which it is determined that the financial guarantee transfers a benefit to the borrower, indicating that, in an arm’s length arrangement, the guarantor should be compensated for providing this benefit.

As mentioned, the analysis may indicate that a guarantee effectively increases the debt capacity of the borrower. In this case, a portion of the loan (the increased debt capacity) from the lender to the borrower may be accurately delineated as a loan from the lender to the guarantor followed by an equity contribution from the guarantor to the borrower. This portion that is effectively linked to an equity contribution from the guarantor should not be considered in evaluating a guarantee fee, the focus would be on the portion that has been accurately delineated as a loan from the lender.

From this stage, the benefit transferred by the guarantor is related to better financing terms, usually a lower interest rate. The next step in the analysis would be to determine an arm’s length compensation for the guarantor, i.e. a guarantee fee. The OECD Guidelines stipulate five methods to determine an appropriate fee. In this article, we reference the “yield approach” and the “valuation of expected loss approach” (VELA). This is not to say the other methods (comparable uncontrolled method, capital support method, and cost approach) are any less effective.

The VELA makes use of probability of default (PD) rates, loss given default rates, expected exposures and discount factors. Determining the PD of a borrower involves understanding where the ultimate default risk is and quantifying this risk into a percentage. The PD of the borrower can be determined using credit rating tools, although perhaps a more astute valuation may require the use of more complicated models (and a bright actuary) that take into account more than just the quantitative factors found in financial statements.

The yield approach is arguably less complex, but can nonetheless provide acceptable results for transfer pricing purposes. As such, in practice we find this approach more commonly applied. The yield approach hones in on the borrowing terms attainable by the borrowing entity based on its credit rating as a member of the MNE group (with the guarantor) and those attainable on the basis of the standalone credit rating of the borrower.

In determining the standalone credit rating of a borrower, credit rating tools typically take into account the country of the borrower, industry, profitability, leverage, growth and stability, interest coverage, and liquidity. Then, by imputing up to six years of the borrower’s financial results, and considering the mentioned factors a credit rating and PD can be produced. It is wise to not take this rating at face value and ensure certain qualitative factors are considered; for example, a rating which is higher than that of the country’s sovereign rating may be a red flag. Ratings agencies typically do not pierce the “sovereign ceiling” because the performance of institutions within a particular sovereignty is perceived to be largely dependent on the country’s economic performance. There are of course exceptions to this rule, but these are largely reserved for the most successful companies in the world.

Once an appropriate standalone credit rating is determined, an interest rate benchmarking is performed to determine the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. The logic behind this is that the interest spread arguably quantifies the benefit gained by the borrower as a result of the guarantee. Through the use of a loan database, ideally one could identify loans with comparable terms to the “tested loan,” granted to independent companies with similar credit ratings to the borrower. In practice, the available loans in public databases are normally issued to investment-grade companies, meaning comparable loans for a borrower with rating of less BBB− are very hard to find, or other important terms, such as currency or tenor (term), are not comparable. The solution, from a transfer pricing perspective, is to turn to slightly different financial instruments such as bonds and debentures.

Bonds are essentially loans secured by a specific physical asset, meaning the holder of a bond can be considered to be the lender while the issuer of the bond acts as the borrower. A debenture, on the other hand, is a debt security issued by a corporation not secured by assets but by the credit rating of the organization. As bonds are more akin to loans, we focus on bonds in this article.

Bonds are highly tradeable, meaning if you purchase a bond, there is usually a market place where you can trade it. Accordingly, there is more public data available, increasing the chances of finding bonds issued under comparable terms to the tested loan. Through bond databases, factors such as the bond’s credit rating, the tenor, the date of issue, currency, and country of issue can be set as filters for a search. By matching these factors to the terms of the tested loan, one can derive a set of comparable bonds. The yield-to-maturity (YTM) or the coupon rate of the comparable bonds is then used to arrive at a range of rates considered to be the arm’s length range for the tested loan based on the borrower’s standalone credit rating.

An acceptable point of this range, such as the median, could then be compared to the interest rate offered to the borrower with the backing of the guarantee. The spread between these rates, as mentioned, could then be considered the quantified benefit of the guarantee. Focusing on the interest rate, if the borrower paid the full spread as a guarantee fee, then the borrower would not gain from a lower interest rate which was derived from engaging with the guarantor. Similarly, the guarantor only receives benefit upon the engagement of a willing borrower. Therefore, the determination of an arm’s length guarantee fee involves splitting the spread between borrower and guarantor as it is a mutually beneficial arrangement. There is no clear guidance on how the split should be determined, however, if one considers a typical joint venture, it may be argued that each party would expect 50% of the benefit for 50% of the contribution. This depends on the arrangement though as a third party may accept any saving when considering the interest expense and guarantee fee together.

The process in practice is often more complicated than the picture we’ve tried to paint and may involve adjustments for currency (through swaps) as well as time (through ascertaining the YTM at issue dates). While the silence on practical guidance from the OECD may be daunting and the right answer may not always be “guaranteed,” carefully considered methodology that aligns with commercial rationale remains, as always, the key to supporting transfer pricing arrangements.

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