Treasurers are often confronted with various types of financial guarantees. Some guarantees are provided as separate bilateral agreements, e.g. in order to secure external funding at a lower financing cost. Other guarantees are part of a larger cash management mechanism, e.g. cross-guarantees between various participating entities in a cash pool. Due to the complex nature of transfer pricing regulation, the pricing of intercompany financial guarantees is often overlooked. This article explores the various types of guarantees and how to price them.
Explicit guarantees
There is only one type of financial guarantee that requires a separate guarantee fee for transfer pricing purposes, i.e. the explicit financial guarantee. This type of guarantee is defined as a written, legally binding commitment of the guarantor to assume the obligations of the guaranteed party in the event of a default. The value of this guarantee is the reduced financing cost of the guaranteed party. Transfer pricing regulation stipulates a remuneration, i.e. internal guarantee fee, in line with this benefit. Various transfer pricing methods exist for explicit guarantees. Discover the most practical approach for your guarantees in our article pricing explicit guarantees: how to select the appropriate method.
Letter of comfort
Any written contract that does not stipulate a binding commitment from the guarantor is thus not considered as an explicit guarantee. Treasury departments would often provide so-called letters of comfort. This type of guarantee thus does not require an internal guarantee fee. This lowers the compliance burden on corporates. Please note that a letter of comfort is considered an indicator of a high level of implicit support.
Implicit group support
Implicit support is defined as the likelihood that a group will assist the resp. subsidiary should it default on its financial obligations. In contrast to the above-mentioned explicit guarantee, it does not require a written agreement nor is it legally binding. It is thus merely an interpretation of the strategic importance of the entity within the group. Establishing the level of implicit support is thus subjective and requires refined substantiation.
Chapter 10 of the OECD guidelines, the UN TP manual and landmark cases are the major regulatory sources to define best-practice characteristics of group support. Each multinational corporation is advised to create a framework to assess implicit group support across all its entities.
Although implicit support does not require a separate guarantee fee, it should be considered when determining a credit rating, e.g. when pricing an intercompany loan. It may have a positive impact on the subsidiary-specific credit rating. More practical information on determining the appropriate level of group support can be found in our articles: how corporates can document implicit support and a best-practice framework for subsidiary credit ratings.
Cross-guarantees
All previously discussed guarantees are bilateral instruments. However, pooling agreements often require cross-guarantees from each participating entity. This legal structure protects against the negative consequences of a default by one of the participants as the other participants will assume the adverse effects. The pricing of cross-guarantees is not required, as per the OECD. It prevents a cumbersome exercise for multinationals.
Conclusion
In conclusion, corporates should charge an internal guarantee fee for explicit financial guarantees. Implicit group support, incl. letters of comfort, should not be priced separately but may influence the internal interest rates of treasury transactions. Cross-guarantees do require an internal guarantee fee.