In our previous Article, we studied transfer pricing implications of cross border inter-corporate loans. In this article, we shall look at transfer pricing implications of cross border corporate guarantees between two Associated Enterprises. Guarantees may be for loan, performance of contract or delivery of products etc. However, we shall restrict our discussion, primarily to loan guarantees though principles discussed herein below would be equally applicable to other types of guarantees. We have maintained the Questions and Answers format for elucidating relevant provisions/law more clearly.
Q What are the different types of Guarantees?
A Meaning of the word Guarantee as per the Oxford Dictionary is:
“An undertaking to answer for the payment or performance of another person’s debt or obligation in the event of a default by the person primarily responsible for it.”
OECD’s Statistical Glossary defines Loan Guarantee as: “A legally binding agreement under which the guarantor agrees to pay any or all of the amount due on a loan instrument in the event of non payment by the borrower.”
Wikipedia defines Loan Guarantee as: “A loan guarantee, in finance, is a promise by one party (the guarantor) to assume the debt obligation of a borrower if that borrower defaults. A guarantee can be limited or unlimited, making the guarantor liable for only a portion or all of the debt.” A Guarantee may be implicit or explicit.
Implicit Guarantee
Implicit guarantee is one when the lender assumes that the borrower being part of a well known group or with financial backing of its parent company, its dues/debts are secured. In case of any unforeseen circumstances, the borrower will be rescued/bailed out by its parent or other group companies.
Implicit guarantees are informal and hence not enforceable in law. Implicit guarantees are not recognised by many countries and normally do not enter the transfer pricing arena.
Explicit Guarantee
Explicit guarantee is one where a formal guarantee agreement is executed whereby the guarantor undertakes to make good loss to the lender in case of default by the borrower. Guarantee commission on explicit guarantees between Associated Enterprises (AEs) needs to be benchmarked on an arm’s length basis applying provisions of the transfer pricing regulations.
Other types of guarantees are letter of comfort/letter of intent whereby the parent company assures the lender that it will safeguard the interest of its subsidiary. This type of guarantee may not have a legally binding force. At times, the parent may undertake to replenish capital in the event of continuing losses which may erode subsidiary’s net worth. Safe Harbour Rules in the Indian Transfer Pricing Regulations clearly define what types of guarantee is covered. The definition of the Corporate Guarantee as per said Rules is as follows:
“Corporate guarantee” means explicit corporate guarantee extended by a company to its wholly owned subsidiary being a non-resident in respect of any short-term or long term borrowing. (Emphasis supplied)
Explanation:– For the purposes of this clause, explicit corporate guarantee does not include letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of a similar nature.
Provisions of the Safe Harbour Rules (SHRs) throw light on the following issues:
• SHRs are applicable for explicit corporate guarantees (Implicit Guarantees and other forms of guarantees are not covered);
• SHRs cover guarantees given by an Indian Company (i.e., only the outbound scenario);
• SHRs are applicable only when a guarantee is given to the Wholly Owned Subsidiary (WOS) and not otherwise;
Q. What are the regulations under FEMA for obtaining and issuing Guarantees by an Indian entity?
A. FEMA Regulations for issuing guarantees:
(Master Circular on Direct Investment by Residents in Joint Venture (JV)/Wholly Owned Subsidiary (WOS) Abroad Para B.1)
Indian entities can offer any form of guarantee – corporate or personal (including personal guarantee by indirect resident individual promoters of the Indian Party)/primary or collateral/guarantee by the promoter company/guarantee by group company, sister concern or associate company in India provided that:
i) All financial commitments including all forms of guarantees are within the overall ceiling prescribed for overseas investment by the Indian party i.e., currently within 100% of the net worth as on the date of the last audited balance sheet of the Indian party.
ii) No guarantee should be ‘open ended’ i.e., the amount and period of the guarantee should be specified upfront. In the case of performance guarantee, time specified for the completion of the contract shall be the validity period of the related performance guarantee.
iii) I n cases where invocation of performance guarantees breach the ceiling for the financial exposure of 100% of the net worth of the Indian Party, the Indian Party shall seek prior approval of the Reserve Bank before remitting funds from India, on account of such invocation.
[Note: In case of invocation of a performance guarantee, which had been issued before 14th August, 2013, the limit of 400% shall be applicable and remittance on account of such invocation over and above 400% of the net worth of the Indian party shall require prior approval of the Reserve Bank.]
iv) A s in the case of corporate guarantees, all guarantees (including performance guarantees and Bank Guarantees/SBLC) are required to be reported to the Reserve Bank, in Form ODI-Part II. Guarantees issued by banks in India in favour of WOS/JV outside India, and would be subject to prudential norms, issued by the Reserve Bank (DBOD) from time to time.
Note: Specific approval of the Reserve Bank will be required for creating a charge on immovable/moveable property and other financial assets (except pledge of shares of overseas JV/WOS) of the Indian party/group companies in favour of a non-resident entity within the overall limit fixed (presently 100%) for the financial commitment subject to submission of a ‘No Objection’ by the Indian party and its group companies from its Indian lenders.
FEMA Regulations for obtaining overseas guarantees: (Foreign Exchange Management (Guarantees) Regulations, 2000, Para 3A)
With prior approval of RBI:
A Corporate registered under the Companies Act, 1956 can avail of domestic rupee denominated structured obligations by obtaining credit enhancements in the form of guarantee by international banks, international financial institutions or joint venture partners.
Without prior approval of RBI:
A person resident in India may obtain without the prior approval of the Reserve Bank, credit enhancement in the form of guarantee from a person resident outside for the domestic debts raised by such companies through issue of capital market instrument like bonds and debentures subject to the following conditions:
• Eligibility:
– A person resident in India
– Other than branch or office in India owned or controlled by a person resident outside India
– I n accordance with the provisions of the
Automatic Route Scheme specified in schedule Automatic route scheme: (Foreign Exchange Management
(Borrowing or Lending in Foreign Exchange) Regulations, 2000, Schedule I, Regulation 6(1)] Borrowing (Guarantee) in Foreign Exchange up to $ 500 million or its equivalent:
Eligibility:
• Any company registered under the Companies Act, 1956, other than a financial intermediary (such as bank, financial institution, housing finance company and a nonbanking finance company)
• The borrowing should not exceed in tranches or otherwise $ 500 million or equivalent in any one financial year (April – March)
End use purpose:
• For investment in real sector – industrial sector including Small and medium enterprises (Sme) and infrastructure sector in india.
• For first stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Governments’ disinvestment programme of PSU shares.
• For direct investment in overseas Joint Ventures(JV)/ Wholly owned Subsidiaries (WoS) subject to the existing guidelines on Indian Direct Investment in JV/WOS abroad.
Q. Whether Guarantee is an “international transaction” under the Indian Transfer Pricing regulations?
A. In one of the earlier rulings on the subject of guarantee, delivered on 9th September, 2011, the hyderabad Tribunal in case of Four Soft limited [(hyd. ITAT) – 62 DTr 308] ruled that:
“The corporate guarantee provided by the assessee company does not fall within the definition of international transaction. The TP legislation does not stipulate any guidelines in respect to guarantee transactions. In the absence of any charging provision, the lower authorities are not correct in bringing aforesaid transaction in the TP study. In our considered view, the corporate guarantee is very much incidental to the business of the assessee and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution. In view of this matter, we hold that no TP adjustment is required in respect of corporate guarantee transaction done by the assessee company.”
However, thereafter the Income tax Act, 1961 (“Act”) was amended vide Finance Act 2012 to bring guarantees and other financial transactions within the ambit of the Transfer Pricing regulations (TPrs). Explanation to section 92B was added to the definition of the term “International Transaction”, which reads as follows (only the relevant extract is reproduced):
“Explanation—For the removal of doubts, it is hereby clarified that—
(i) the expression “international transaction” shall include—
(c) Capital financing, including any type of long-term or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;”
from the above, it is clear that loans and guarantees between AEs are covered under the TPRs of India retrospectively
w.e.f. 1st april 2002.
Post the above amendment, divergent rulings of the tribunals have come which are enumerated hereunder:
i) Bharati Airtel Ltd. vs. ACIT [2014] 43 Taxmann.com 150 (delhi – trib.)
In this case, the tribunal held that “even after the amendment to Section 92 B, by amending explanation to section 92 B, a corporate guarantee issued for the benefit of the aes, which does not involve any costs to the assessee, does not have any bearing on profits, income, losses or assets of the enterprise and or therefore, it is outside the ambit of ‘international transaction’ to which ALP adjustment can be made.”
ii) The mumbai tribunal, in cases of (a) Everest Kanto Cylinder Ltd. vs DCIT (ITA No. 542/Mum/2012) and (b) Technocraft Industries (India) Ltd. vs. ACIT (ITA No.7519/ Mum/2011), Mumbai (January 2014) held that post amendment of section 92B guarantee transactions are covered by the Transfer Pricing Regulations.
Safe harbor Provisions as applicable to Guarantee transactions [Notified on 18th September 2013 applicable for Five Assessment years beginning from Ay 2013-14]
|
Sr.
No.
|
Eligible
Interna- tional Transactions
|
Acceptable
Circumstances
|
Remarks
|
|
1
|
Providing
corpo- rate guarantee where the amount guaranteed does not exceed Rs.100
crore.
|
Guarantee
com- mission or the fee charged
should be minimum
2% per annum of the amount guaranteed.
|
Corporate
Guar- antee is defined to mean explicit corporate guaran- tee extended by a
company to
its WOS being a non-resident in respect of any short-term or long term
borrowing.
|
The Australian Taxation Office in its Discussion Paper on “Intra-group Finance Guarantees & Loans Application of Australia’s Transfer Pricing and Thin Capitalization Rules
Between AES be given without charging any commission?
A. Post amendment of section 92B of the Act, transactions of cross border Guarantees between two aes are covered under the transfer pricing regulations. however, we have divergent decisions from tribunals on this point. (Refer Ans. 3 supra)
OECD Guidelines on Transfer Pricing (Para 7.13) provide intra-group services are said to be rendered when an AE derives benefits from an active association in the form of explicit guarantee from a group member and/or global marketing and promotion of the group whereas no services are said to be rendered where there is incidental benefits due to passive association of the ae with its group members. in the former case, issuance of guarantee would demand charging whereas, in the later case there is no need of any charge as no services are said to be rendered.
Australian Discussion Paper (2008) (paragraph 31) on “intra-group finance Guarantees and loans” states that “incidental benefits from association with a larger group where the market accords those benefits without an associated company actually providing an economic service that confers a benefit on the recipient would not usually be a basis for imposing a charge.”
From the above discussion, one may conclude that in the following circumstances, intra-group guarantees may not carry any charge or commission and therefore, are out of ambit of the transfer pricing regulations:
i) When the benefit obtained by an AE is on account of a passive association (something akin to implicit guarantee);
ii) When the corporate guarantee is issued for the benefit of the ae, which does not involve any costs to the assessee and therefore does not have any bearing June 2008” (paragraph 181 on page 42 of the Paper) has opined that where the provision of a guarantee relates exclusively to the establishment or maintenance of a parent company’s participation as an investor, the costs of such participation should not be allocated to the subsidiary and should not affect the allocation of profit between the parent and subsidiary. in such a circumstance it could be fair and reasonable to determine that the arm’s length consideration for the provision of the guarantee is nil. On profits, income, losses or assets of the Guarantor (Based on the
decision of the delhi tribunal in case of Bharati Airtel (I.T.A. No.
5816/Del/2012));
iii) Where the guarantee is provided for the debt which is in lieu of equity or which is in the nature of equity.
At Paragraph 105 of the Paper it is reported that: “The pricing of a guarantee is calculated as a percentage or spread on the amount of the debt being guaranteed. no chargeable percentage or spread arises on any portion of the debt that serves the purposes of equity.”
Q. What are the provisions under the OECD Transfer Pricing Guidelines regarding cross border guarantees?
A. Paragraph 7.13 of the (Chapter VII- Intra-Group Services) OECD Guidelines on Transfer Pricing (July 2010) makes a distinction between an “active association” and a “passive association” between aes. according to the Guidelines, in case of a passive association, an AE would receive incidental benefits just because it is part of the multinational enterprise Group. in such a scenario, no services are said to be rendered even though it receives higher credit rating being affiliated to a larger group. however, in case of an active association, services are said to be rendered when the ae receives higher credit rating because of guarantee offered by another group member or benefit obtained from the group’s reputation deriving from global marketing and public relation campaigns.
Benefit on account of “passive association” is akin to “implicit guarantee” whereas, benefit on account of “active association” is akin to “explicit guarantee”. therefore, even oeCd supports the view that there is no need of any charge in the case of implicit guarantee whereas explicit guarantee needs to be charged and benchmarked under transfer pricing regulations.
Q. how does one benchmark guarantee fee?
a. Benchmarking of guarantee fee is a complex issue in view of unavailability of comparable data and unique nature of the transaction.
Various methods or approaches can be used to benchmark a guarantee fee depending upon the facts of the case and availability of the comparable data. Various situations and appropriate methods/approaches are discussed in the Australian Discussion Paper (2008) (paragraphs 128 to 171) on “intra-group finance Guarantees and loans” as well as arising from different case laws, as follows:
i) CUP Method
CUP Method is the most appropriate method where sufficient data for comparison are available.
Under this method, the guarantee fee is determined by comparing the arm’s length guarantee fee charged by an independent party for providing similar guarantee on similar terms and conditions. in this approach, quantum of risk, type of guarantee, period of guarantee, borrower’s standalone credibility etc. are considered for arriving at arm’s length guarantee fee.
There may be Internal CUP or External CUP. In the case of the former, the spread between guaranteed and non-guaranteed third party loans are compared and the guarantee fee charged is equivalent or more due to difference in interest rates between these two types of loans.
In case of External CUP the fees applicable to Letter of Credit or Collateral debt Securities data are used.
The CUP method would be ideal in cases where a creditworthy subsidiary that is able to raise the debt funding it needs on a stand-alone basis obtains better terms with the benefit of a parent guarantee.
ii) Benefit/yield Approach
This approach is also known as “interest Saving approach”. in this method, arm’s length guarantee fee is determined through the interest rate saving which the subsidiary earns due to explicit guarantee by its parent. Thus, this method/approach seeks to benchmark the guarantee fee from the perspective of the borrower.
Under this approach, uncontrolled interest rates, risk assessments and market indicators are used as indirect benchmarks for arriving at the arm’s length fee, rather than using uncontrolled guarantee fee as a benchmark.
In other words, an arm’s length fee is estimated as the spread between the interest rate the borrower would have paid without the guarantee and the rate it pays with the guarantee, less the arm’s length discount. the remaining spread, net of the discount, would have to be sufficient to make the deal attractive to an independent guarantor for the additional risk it would assume, if it provided the guarantee. if there is no additional risk, then consideration has to be given to the economic substance of the arrangement between the parties.
In the case of General electric Capital Canada inc.’s in december 2009 (Ge Capital), the tax Court of Canada (TCC) (2009 TCC 563 Date: 20091204)
Upheld the yield approach for determination of arm’s length fee for the explicit guarantee provided to the Canadian subsidiary (GE Canada) by the US Parent Co. (Ge uSa).
In the case of Four Soft Ltd. vs. DCIT [(Hyd. ITAT)
– 62 DTR 308], the Tribunal, while upholding non charging of guarantee fees by the indian Company in respect of overseas aes observed that “the subsidiary company has not received any benefit in the form of lower interest rate by virtue of the corporate guarantee given by the assessee company and at the same time, the assessee company significantly benefited from such transaction”. Thus the Tribunal did look at the “benefit approach” in benchmarking guarantee fees.
iii) Profit Split Method
this method is useful where there are series of transactions owing to special relationship between the parent company and its subsidiary.
For example, the parent may supply trading stock to a subsidiary, purchase outputs from the subsidiary and also provide debt funding and a guarantee. There may be benefits flowing from the parent to the subsidiary as well as from the subsidiary to the parent. Such cases require a careful analysis of benefit flows and their impacts on the respective parties in order to appropriately determine the share of profit each party should receive for its contribution to the profit channel.
iv) Risk/Reward Based Approach or Cost Based approach
This approach takes into account the risk the parent would take in extending guarantee to its subsidiary/ ae in the event of default and reward it in terms of increased profitability and sustainability or viability of subsidiary’s business. the reward could also be based on the quantified risk and perceptions of the probability that the risk will not materialise compared to the probability that it will materialise.
This approach seeks to value the guarantee fee from the perspective of the guarantor by focussing on the actual and potential financial and other impacts of providing guarantee. The benchmarking is done as if such guarantee transaction is entered into by two independent parties taking into account the circumstances of the borrower. The borrower’s creditworthiness [to be determined based on arm’s length, i.e., as if it is an independent enterprise] is of utmost importance as it has a direct bearing on its financial strength and the default risk.
v) The other two approaches are, namely: (i) option Pricing Model Approach [Using financial model for valuing options where the guarantee fee is ascertained as equivalent to a premium chargeable for insuring the underlying loan asset] or (ii) Credit Default Swaps [which is akin to a financial guarantee where a parent would make a periodic fixed payment to a third party should the subsidiary default on its obligation].
Both the above approaches are not much in vogue and hence not discussed at length.
In actual practice, especially in complex cases a combination of various approaches may be used.
Q. What are the Judicial Precedents for benchmarking of cross border guarantees?
A. Indian experience and judicial precedents (in addition to cases discussed hereinabove) on charging of guarantee fees are summarised as follows:
Indian Experience
Indian Transfer Pricing Administration prefers CUP method for benchmarking guarantee commission in cases of outbound guarantees (i.e., where indian company has given guarantee to its overseas ae). in most cases, interest rate quotes and guarantee rate quotes available from banking companies are taken as the benchmark rate to arrive at the ALP. The Indian tax administration also uses the interest rate prevalent in the rupee bond markets in india for bonds of different credit ratings. the difference in the credit ratings between the parent in india and the foreign subsidiary is taken into account and the rate of interest specific to a credit rating of indian bonds is also considered for determination of the arm’s length price of such guarantees.
In the above context, it is interesting to note the observations of the hyderabad tribunal in case of four Soft limited (supra) wherein the tribunal observed that “in our considered view, the corporate guarantee is very much incidental to the business of the assessee and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution.”
In case of M/s. Asian Paints Ltd. vs. ACIT (ITA No. 408/ Mum/2010), the Mumbai Tribunal upheld following observations of the Cit (a) which are worth noting:
“The TPO has collected data from the Website of Allahabad Bank, hSBC Bank and robo india finance and applied the flat rate of 3%. That is to say the TPO has adopted a ‘naked quote’ without factoring in the qualitative factors which determine the fees. a quotation given by a third party e.g. a Banker does not constitute a CUP since it is quotation and not an actual uncontrolled “transaction”. the TPO has adopted a 3% rate or guarantee fees when the Citi Bank Singapore (the bank providing the loan amount) itself has charged interest at the rate of 1.625% only on the loan granted to its ae at Singapore. this makes the stand of the TPO unsustainable as guarantee fees can in no circumstances exceed the rate at which interest is charged on loan.”
From the above, two principles emerge which are as follows:
(i) Banks’ quotes of “Guarantee Commission” cannot be applied blindly (naked quote) without factoring into qualitative factors thereunto
(ii) Under no circumstances, guarantee fees can exceed the rate of interest charged on the underlying loan for which guarantee is given.
In the case of Reliance Industries Ltd. [I.T.A. No.4475/ Mum/2007], the Mumbai Tribunal held as follows:
(i) Guarantee transactions do fall within the definition of the “International Transaction” under the Transfer Pricing regulations post retrospective amendment of section 92B of the act vide the finance act 2012;
(ii) For benchmarking of guarantee fees, one cannot apply any naked bank rate, as guarantee fee largely depends upon the terms and conditions on which loan has been given, risk undertaken, relationship between bank and the client, economic and business interest etc.
In the case of Glenmark Pharmaceuticals Limited vs. ACIT [TS-329-ITAT-2013(Mum)-TP], the Mumbai Tribunal also held as follows:
(i) CUP is the most appropriate method for benchmarking Guarantee transactions.
(ii) There is a conceptual difference between Bank Guarantee and Corporate Guarantee. Bank Guarantee is a foolproof instrument of security for the customer and failure to honour the guarantee is treated as deficiency of services of the Bank under the Banking laws. on the other hand, the CG – Corporate Guarantee is provided by the Company either to the Customer or to the Bank for giving loans to the sister concerns/AEs of the said company; but it is not foolproof. failure to honour the guarantee may attract contract laws and it is however a legally valid document and the Customer/Bank can sue the company in Court if it does not pay up.
(iii) Unless the ‘naked quotes’ of the bank guarantee rates as given in the websites for public, are adjusted to various controlling factors, these rates are no good CUP.
(iv) Conclusion:
From the above discussion, it can be concluded that guarantee given by an Indian Parent to its overseas subsidiary needs to be benchmarked as per transfer pricing regulations in India. The CUP method is ideal subject to availability of comparable data. in complex cases one or more methods/approaches can be used. Indian Safe harbour provisions provide considerably higher rate of guarantee commission/fees and therefore, less likely
to be opted by assesses in india.
Benchmarking of guarantee is never an easy task in view of commercial exigencies and other factors involved. The Indian Transfer Pricing Administration (ITPA) should therefore adopt a comprehensive approach in arriving at arm’s length fees rather than adopting naked rates/fees as are quoted on the website of the Banks/Financial Institutions. It would be interesting to see whether the ITPA would be willing to allow as deduction guarantee commission/fee charged by the foreign parent to its indian subsidiary based on the bank rate.
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