Determining the appropriate internal guarantee fee is not an easy task for most treasurers and tax departments. The OECD puts forward five different transfer pricing methods. This article highlights the common pitfalls when pricing guarantees as well as the practical considerations of each method.
Common pitfalls
A common misperception around which guarantees require a guarantee fee may cause corporates to price the wrong types of guarantees or not price any at all. This leaves the corporate with a high level of tax audit risk. More information on which guarantees require an internal fee can be found in our related article Which guarantees require pricing?.
Unfortunately, some corporates that do price the correct types of transactions rely on unacceptable methods. A common approach would be to base the intercompany guarantee fee on one or multiple bank quotes as relationship banks would sometimes mention the cost of a bank guarantee for a similar guarantee as the intercompany financial guarantee. Although the quality of the quote depends on the effort put in by the bank, it will not be accepted by tax authorities. The OECD disregards bank quotes as they do not represent actual transactions. Using bank quotes as substantiation for your guarantee fees thus leaves each corporate in a vulnerable position during a tax audit.
CUP method
The CUP method is the preferred method for many types of transactions, e.g. for most intercompany loans. The pricing according to this method would be based on the pricing of comparable guarantees. Both internal and external comparables are accepted by the OECD guidance if the economic circumstances are analogous. However, external comparables are unlikely to be found as market data is barely available. Therefore, this method is difficult to apply from a practical perspective.
Capital support method
The capital support method assumes that the credit rating of the guaranteed subsidiary can be brought to the same level as the credit rating of the guarantor by solely increasing its capital. Therefore, the guarantee fee should equal the expected return of the incremental capital. Nevertheless, it should be noted that credit ratings are not only based on capital-based ratios. This method is thus highly subject to model risk and is therefore often not preferred. Should the corporate be able to estimate the credit rating of both the guarantor as well as the guaranteed entity, it would be appropriate to consider on the yield method.
Yield method
The yield method is the most practical approach for most multinationals. Corporates can leverage a solid CUP methodology for intercompany loans to price their explicit guarantees with this method. More information on how to apply the CUP method for loans can be found in our dedicated article: Common pitfalls: how to consistently apply the CUP method for IC loans.
The method stipulates that the maximum guarantee fee would correspond with the maximum willingness to pay of the guaranteed entity. This aligns with the reduced funding cost resulting from the guarantee. Having a solid CUP methodology in place allows corporates to calculate the required components, i.e. the arm’s length funding cost with the group rating and with the subsidiary-specific credit rating.
Cost method
The cost method will give corporates an estimation of a minimum guarantee fee. The cost incurred by providing the guarantee largely corresponds with the expected credit loss. Various models exist, such as option pricing, to determine the cost of the guarantee. However, it is possible to calculate the expected loss in line with capital requirements, i.e. incorporating the probability of default, exposure at default and loss given default throughout the tenor of the guarantee.
Conclusion
Corporates are advised to understand which guarantees require pricing in order to ensure that all relevant guarantees are identified for pricing. Replacing a pricing process based on bank quotes can require an initial effort. However, corporates are advised to leverage their loan pricing methodology to estimate a maximum guarantee fee using the yield method. This can be further complemented with a minimum guarantee fee through an expected loss calculation, resulting in an acceptable bandwidth for the guarantee fee.