OECD on Financial Guarantees

In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. In general, a financial guarantee provides for the guarantor to meet specified financial obligations in the event of a failure to do so by the guaranteed party. There are various terms in use for different types of credit support from one member of an MNE group to another. At one end of the spectrum is the formal written guarantee and at the other is the implied support attributable solely to membership in the MNE group. Here we use guarantee to mean a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation. The situation likely to be encountered most frequently in a transfer pricing context is that in which an associated enterprise (guarantor) provides a guarantee on a loan taken out by another associated enterprise from an unrelated lender. From the borrower perspective, a financial guarantee may affect the terms of the borrowing. For instance, the existence of the guarantee may allow the guaranteed party to obtain a more favorable interest rate since the lender has access to a wider pool of assets, or to increase the amount of the borrowing. From the perspective of the lender, the consequence of an explicit guarantee is that the lender’s risk would be expected to be reduced by having access to the assets of the guarantor in the event of the borrower’s default. Effectively, this may mean that the guarantee allows the borrower to borrow on the terms that would be applicable if it had the credit rating of the guarantor rather than the terms it could obtain based on its own, non-guaranteed rating. A number of methods can potentially be used to value guarantees. The yield approach calculates 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 interest spread can be used in quantifying the benefit gained by the borrower as a result of the guarantee. The cost method aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee. Popular pricing models for this approach work on the premise that financial guarantees are equivalent to another instrument and pricing the alternative, for example treating the guarantee as a put option and using an option pricing model to price the put option. The valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default.

Background. In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. The OECD expects that the Guidance should contribute to consistency in the application of transfer pricing and help to avoid transfer pricing disputes and double taxation.

The Guidance is divided into several parts. First, the Guidance elaborates on how “accurate delineation” analysis applies to the capital structure of a Multinational Enterprise (“MNE”). See prior post. Regarding accurate delineation, the Guidance makes clear that it does not seek to prevent countries from implementing approaches to address capital structure and interest deductibility under domestic legislation. Subsequent sections of the Guidance address specific issues related to the pricing of financial transactions, such as treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance. Those issues are the subject of separate posts. This post covers pricing of financial guarantees.

For MNE groups, the management of group finances is an important and potentially complex activity where the approach adopted by individual businesses will depend on the structure of the business itself, its business strategy, place in the business cycle, industry sector, and currencies of operation, among other factors. Different treasury structures involve different degrees of centralization. In the most decentralized form, each MNE within the group has full autonomy over its financial transactions. At the opposite end of the scale, a centralized treasury has full control over the financial transactions of the MNE group, with entities within the MNE group responsible for operational but not financial matters. A key function of corporate treasury may be to optimize liquidity across the MNE group to ensure that the business has sufficient cash available and that it is in the right place when it is needed and in the right currency. Other activities that treasury may have responsibility for include raising debt (through bond issuances, bank loans or otherwise) and raising equity, and managing the relationship with the MNE group’s external bankers and with independent credit rating agencies. Generally, the treasury function is part of the process of making the financing of the MNE group as efficient as possible. For example treasury may act as the contact point to centralize the external borrowing of the MNE group. External funds would then be made available within the MNE group through intra-group lending provided by the treasury.

Financial guarantees. In general, a financial guarantee provides for the guarantor to meet specified financial obligations in the event of a failure to do so by the guaranteed party. There are various terms in use for different types of credit support from one member of an MNE group to another. At one end of the spectrum is the formal written guarantee and at the other is the implied support attributable solely to membership in the MNE group. Here we use guarantee to mean a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation. The situation likely to be encountered most frequently in a transfer pricing context is that in which an associated enterprise (guarantor) provides a guarantee on a loan taken out by another associated enterprise from an unrelated lender.

Economic benefit from a financial guarantee. The accurate delineation of financial guarantees requires initial consideration of the economic benefit arising to the borrower beyond the one that derives from passive association. From the borrower perspective, a financial guarantee may affect the terms of the borrowing. For instance, the existence of the guarantee may allow the guaranteed party to obtain a more favorable interest rate since the lender has access to a wider pool of assets. Alternatively, the guarantee may allow the borrower to increase the amount of the borrowing. From the perspective of the lender, the consequence of an explicit guarantee is that the lender’s risk would be expected to be reduced by having access to the assets of the guarantor in the event of the borrower’s default. Effectively, this may mean that the guarantee allows the borrower to borrow on the terms that would be applicable if it had the credit rating of the guarantor rather than the terms it could obtain based on its own, non-guaranteed, rating. When the effect of the guarantee is to reduce the cost of debt-funding for the borrower, it might be prepared to pay for that guarantee, provided it was in no worse a position overall. In considering the borrower’s overall financial position as a result of the guarantee, its cost of borrowing with the guarantee (including the cost of the guarantee and any associated costs of arranging the guarantee) would be measured against its non-guaranteed cost of borrowing, taking into account any implicit support.

Access to a larger amount of borrowing. The effect of the guarantee may not simply be supporting the credit rating of the borrower but could be acting both to increase the borrowing capacity and to reduce the interest rate on any existing borrowing capacity of the borrower. According to the OECD, in such a situation there may be two issues: first, whether a portion of the loan from the lender to the borrower is accurately delineated as a loan from the lender to the guarantor (followed by an equity contribution from the guarantor to the borrower), and, second, whether the guarantee fee paid with respect to the portion of the loan that is respected as a loan from the lender to the borrower is at arm’s length.

Effect of group membership. By providing an explicit guarantee the guarantor is exposed to additional risk, as it is legally committed to pay if the borrower defaults. Anything less than a legally binding commitment such as a “letter of comfort” or other lesser form of credit support, involves no explicit assumption of risk. Generally, in the absence of an explicit guarantee, any expectation by any of the parties that other members of the MNE group will provide support to an associated enterprise in respect of its borrowings will be derived from the borrower’s status as a member of the MNE group. The benefit of any such support attributable to the borrower’s MNE group member status would arise from passive association and not from the provision of a service for which a fee would be payable.

A similar issue arises in respect of cross-guarantees, where two or more entities in an MNE group guarantee each other’s obligations. From the lender’s perspective it has access to the assets of every cross-guaranteeing entity in the event of default by a guaranteed borrower. Not only is this complex from the perspective of potentially large numbers of guarantees to be evaluated, but also because each party providing a guarantee may in turn be guaranteed by the party for whom it is now acting as guarantor. An analysis of the facts may lead to the conclusion that such an arrangement does not enhance the credit standing of an MNE group member beyond the level of passive association.

Financial capacity of the guarantor. The examination of financial guarantees needs to consider the financial capacity of the guarantor to fulfill its obligations in case of default of the borrower. This requires an evaluation of the credit rating of the guarantor and the borrower, and of the business correlations between them. A lender would benefit from the stronger credit rating of the guarantor (compared to the borrower’s credit rating) and/or the guarantor’s asset pool (in addition to the borrower’s asset pool), and the borrower accordingly may expect a benefit in the form of a lower interest rate. Based on the facts and circumstances, a guarantee may provide a benefit to the borrower that has the same or higher credit rating as the guarantor, if the guarantee effectively allows the lender to access wider recourse and, therefore, reduces the interest rate, despite the guarantor not having a higher credit rating.

CUP Method. The CUP method could be used to price a guarantee where there are external or internal comparables; independent guarantors providing guarantees in respect of comparable loans to other borrowers or where the same borrower has other comparable loans which are independently guaranteed. The difficulty with using the CUP method is that publicly available information about a sufficiently similar credit enhancing guarantee is unlikely to be found between unrelated parties given that unrelated party guarantees of bank loans are uncommon.

Yield approach. The yield approach quantifies the benefit that the guaranteed party receives from the guarantee in terms of lower interest rates. The method calculates 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 interest spread can be used in quantifying the benefit gained by the borrower as a result of the guarantee. In determining the extent of the benefit provided by a guarantee, it is important to distinguish between the impact of an explicit guarantee from the effects of any implicit support as a result of group membership. The result of this analysis sets a maximum fee for the guarantee, namely, the difference between the interest rate with the guarantee and the interest rate without the guarantee but with the benefit of implicit support.

Cost Approach. This method aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee. Popular pricing models for this approach work on the premise that financial guarantees are equivalent to another instrument and pricing the alternative, for example treating the guarantee as a put option and using an option pricing model to price the put option.

Valuation of expected loss approach. The valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default. This would then be applied to the nominal amount guaranteed to arrive at a cost of providing the guarantee.

Capital Support Method. The capital support method may be suitable when the difference between the guarantor’s and the borrower’s risk profiles could be addressed by introducing more capital to the borrower’s balance sheet. It would be first necessary to determine the credit rating for the borrower without the guarantee (but with implicit support) and then to identify the amount of additional notional capital required to bring the borrower up to the credit rating of the guarantor. The guarantee could then be priced based upon an expected return on this amount of capital.

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