California Bar Member Calls for Guidance on Transfer Pricing of Financial Guarantees

Contact Person:

A subsidiary may be required to pay an arm's length fee to a parent company in exchange for receiving a financial guarantee under the transfer pricing rules of Section 482. The idea is that the subsidiary has received a benefit (a notch up in its credit ratings) as a result of receiving a service from the parent company (i.e., providing the financial guarantee). However, there is minimal guidance as to when a financial transaction should be compensable, what the effect of the affiliation should be when considering the economic benefit of the financial guarantee, and the proper method for valuing the transaction.

This paper explores the key issues relating to financial guarantees and provides a framework for discussion in promulgating guidance on this pressing issue. This paper proposes the following specific recommendations:

A. Example 1: Parent Company as Service Provider

If one member of a group of controlled taxpayers (the renderer) performs a service for, or on behalf of, another member of the same group of entities with no compensation or compensation below an arm's length charge, the Commissioner has the authority under Section 482, and the transfer pricing regulations, to make appropriate allocations of income and expenses as necessary to reflect an arm's-length charge for the service.⁵

This can best be illustrated by example. Assume that a U.S parent company provides a service to a wholly-owned subsidiary in Country B. In this instance, the subsidiary may be required, in certain circumstances, to pay a fee to the parent in exchange for the services.

 

 

Another example is where a parent company with a stronger credit rating or balance sheet contractually guarantees the borrowings of its subsidiary at no charge. The guarantee allows the subsidiary to obtain financing at more advantageous terms from a third party lender or bank.

 

 

C. Example 3: Passive Association/Benefit Scenario

A final example is where the credit worthiness or reputation of a parent corporation allows a subsidiary, who is unable to borrow on a stand-alone basis, to obtain credit or to contract with third party lenders on terms that are more favorable than if the subsidiary were not affiliated with the parent.

 

 

D. Substantial Need for Guidance

Financial guarantees present some complex policy issues; consider the following. If the activities of the parent company are de minimus (e.g., the parent company is merely a passive actor) in these types of financial transactions, do the administrative costs and burdens placed on the taxpayer in complying with Section 482's requirements exceed the related tax revenues? Does a policy of imposing unreasonable compliance costs on taxpayers inhibit the ability to benefit from international trade? These are some of the issues faced when dealing with financial guarantees.

As the global marketplace becomes ever more accessible, financial guarantees by a rich parent company to less well-situated affiliate companies are common. This may be particularly true with respect to the motion picture industry in Los Angeles and high-technology companies in Silicon Valley. The effects of the recession and tightening of the credit markets have caused banks to demand more credit support from shareholders or affiliates of companies seeking loans. The issue of the proper tax treatment of financial guarantees is being encountered more frequently in audits of multinational corporations. Yet surprisingly there is little guidance on whether Section 482 applies to these transactions, and if it does, what is the proper pricing or valuation of financial guarantees.

The Service has wrestled for some time with the application of Section 482 to controlled services transaction. The IRS recently issued regulations, which are intended to provide guidance regarding methods of determining taxable income in connection with controlled services transaction. Yet the regulations expressly carve-out financial transactions, including guarantees, from application of the Services Costs Method in the regulations and intentionally left open the question as to whether, and to what extent, Section 482 should apply to financial and performance guarantees. The absence of guidance in this area creates uncertainty and potential controversy over the recognition and pricing of such financial transactions.

The Secretary has acknowledged the need for guidance on this pressing topic. The author is advised that the Secretary is most interested in receiving comments and views with respect to the applicability of Section 482 to financial guarantees and credit support arrangements. The National Office may open a new regulation project on this issue, which underscores the importance and merits of the problem addressed herein.

Section 482 authorizes the Secretary to allocate income between controlled enterprises if it determines that such an allocation is necessary to prevent evasion of taxes or clearly to reflect the true income of the controlled enterprises. Section 482 provides:

Examples of controlled services transaction -- transactions by one member of a group of controlled taxpayers that results in a benefit to another member of the controlled group -- include the following:⁷

Where one member of a group of controlled entities performs marketing, managerial, administrative, technical, or other services for the benefit of, or on behalf of another member of the group without charge, or at a charge which is not equal to an arm's length charge, the IRS may make appropriate allocations to reflect an arm's length charge for such services.⁸ This general principal may be illustrated by the following example:

The former safe-harbor provision is inapplicable if the services are an integral part of the business activity of either the member rendering the services or the member receiving the benefit of the services.¹² A service is considered an integral part of a member of a controlled group where:

Additionally, the new regulations replace the prior safe harbor which was based on the charge of direct and indirect costs for non-integral services with the services cost method, listed above. The services cost method specifies that the arm's length charge is the total service costs (direct and indirect costs) without a markup.¹⁶ The services cost method will be considered the best method, if the covered services meet one of the following conditions:

Should a financial guarantee constitute the performance of a service so as to fall within the scope of the pricing principles of Treas. Reg. § 1.482-9? In General Counsel Memorandum (GCM) 38499 (Sept. 19, 1980), the Commissioner agreed with a proposed revenue ruling concluding that the "guarantee of the parent constitutes the performance of a service for the subsidiary." The Commissioner relied upon Treas. Reg. § 1.482-2(b)(7)(v), Example (9), to reach this result:

Most recently, in Container Corporation et al., v. Commissioner,²⁷ the Tax Court considered the nature of financial guarantees in order to determine whether fees paid by a US subsidiary to its foreign parent should be subject to a U.S. Withholding Tax. Several alternatives were considered. First, although the amount of the fees paid to the foreign parent was expressed as a percentage of average outstanding loan balance, the Court quickly dismissed any notion that guaranty fees were in the nature of an interest charge on forbearance since the guarantor was not required to extend funds during the term of the guaranty, but merely stand by to do so if called upon. The Court next asked whether the guaranty could be characterized as a "service." Not finding any clear guidance in the statute, regulations or case law as to the definition of a "service," the court looked to the dictionary:

Because the controlled parties in the Container case actually charged a guaranty fee which the Service did not challenge pursuant to Section 482 as either excessive or inadequate, not much can be taken from the opinion other than a deeper understanding of the challenges faced by the taxing authority in trying to define circumstances when fees should be charged and how they should be measured. As will be discussed below, the United States is not the only jurisdiction that is struggling to grasp these questions.

A. What Constitutes a Financial Guarantee?

A starting point is to provide guidance as to what constitutes a "financial guarantee" for purposes of controlled services transactions under Section 482. No definition exists in the regulations, and a clear working definition would greatly assist taxpayers in ascertaining whether a particular financial transaction falls within the scope of Section 482.

The Australian Tax Office ("ATO") has provided meaningful guidance as to what constitutes a financial guarantee or credit support arrangement in a paper entitled, Intra-group Finance Guarantees and Loans -- Application of Australia's Transfer Pricing and Thin Capitalization Rules, June 2008("ATO Paper"). The ATO defines the term "financial guarantee" as follows:

Building upon the principles set forth by the Australian Tax Office, this Paper proposes the following definition of "financial guarantee":

• A financial guarantee is a commitment by a parent company that it will meet the liabilities arising under the terms of a loan from an independent party in the event of a default by the borrowing subsidiary.

• A financial guarantee may be an explicit credit support arrangement, which is a contractually binding legal commitment, whether a guarantee, letter of comfort or other assurance.

• A financial guarantee may be an implicit credit support arrangement such as: (i) a letter of comfort or similar statement of intent which does not constitute a contractually binding commitment; or (ii) a credit support obtained as an incidental benefit from the taxpayer's passive affiliation with a member of the group of controlled taxpayers.

• Other forms or arrangements of financial guarantees may exist.

B. The Case of Passive Association³⁰

In dealing with financial guarantees between members of a group of controlled taxpayers, one scenario to consider is whether a subsidiary should be required to pay a service fee to a parent company, where the subsidiary's economic benefit results from its status as a member of a controlled group and not to any specific activity by the parent company.

This Paper recommends that no service fee should be charged in this case and that the IRS issue guidance in accordance with this recommendation. The regulations, as well as additional authority, clearly support this recommendation, as shown below.

An activity is not considered to provide a benefit to the recipient if, at the time the activity is performed, the present or reasonably anticipated benefit is so "indirect or remote" that the recipient would not be willing to pay an uncontrolled party to perform a similar activity, and would not be willing to perform such activity for itself for this purpose.³³ The determination whether the benefit from an activity is indirect or remote is based on the nature of the activity and the situation of the recipient, taking into account all facts and circumstances.³⁴

The regulations specifically carve-out "passive associations" when referring to the rendering of a "benefit." The regulations state:

In short, the regulations clearly take the position that there should be no service charge in the case of passive association.

C. The Case of Active Association

The next scenario to consider is where a parent company undertakes some level of activity that results in conferring a financial benefit to a subsidiary. A parent company's active participation can take various forms from merely sending a letter of comfort to executing a explicit credit support agreement, whereby the parent company agrees to legally stand behind the subsidiary in the event of a default on a loan.

The central question is under what circumstances does the relationship between a parent company and a subsidiary rise to the level of triggering Section 482 and require an arm's length pricing adjustment? The answer to this questions turns, in part, on the category of credit support arrangement involved in the transaction.

The Australian Tax Authority agrees with the regulations that a service fee should be charged where a parent company executes an explicit credit support arrangement.⁴² Likewise, the Canadian Tax Court reached a similar result in General Electric Capital Canada Inc. v. Her Majesty The Queen, 2009 TCC 563 (Dec. 4, 2009), where the Court found that GE was entitled to deductions for C $136 million in guarantee payments it made to the U.S.-based General Electric Capital Corp. between 1996 and 2000. This case is discussed more fully below.

Accordingly, the IRS should issue guidance as to under what circumstances is an explicit credit support arrangement a compensable transaction.

The Australian Tax Authority agrees with the regulations that no fee should be charged where the parent company merely furnishes a letter of comfort or other similar statement of intent. The ATO Paper states, in part:

In summary, an "implicit credit support" arrangement should not be a compensable transaction in the case where a parent company merely provides a letter of comfort or similar statement of intent which does not constitute a contractually binding commitment, absent a showing by the taxpayer as to why a charge should be justified under the facts and circumstances. This IRS should consider issuing guidance along these lines.

D. Valuation of Financial Guarantees

There is often a lack of comparable data upon which to value a financial guarantee. Take for example the situation where a parent company provides a guarantee to a subsidiary that is unable to borrow the funds that it needs on a stand-alone basis. This scenario raises the basic question as to whether an independent party would provide a guarantee to support the borrowing of a company that could not borrow in its own right. In these types of cases, it is unlikely that an arm's length consideration will be able to be ascertained from market data because independent comparables are unlikely to exist.

Both the Australian Tax Office and the Canadian Tax Court have considered the issue of valuing financial guarantees, and their reasoning and commentary is helpful guidance on this issue.

In short, the spread valuation method suggested by the Australian Tax Office is one way to objectively value a financial guarantee.

There, parent company General Electric Capital Corporation (GE USA) guaranteed payments due under securities issued by subsidiary GE Capital Canada Inc. (GE Canada) and charged a one percent per annum fee for the guarantees.⁴⁹ The Minister of National Revenue (the "Minister") denied the deductions for guarantee fees claimed by GE Canada.⁵⁰ The Minister contended that GE Canada received no economic benefit from the guarantee, and, as a result, the "arm's length" price for the guarantee should be zero.

The Canadian Tax Court held in favor of GE Canada, allowing it to maintain as a deductible expense 100 percent of the guarantee fee paid to GE USA. The Court reasoned, in part, that the explicit guarantee raised GE Canada's credit rating and lowered its borrowing costs. To value the financial guarantee, the Court appeared to adopt a yield approach, whereby the interest cost savings is determined based upon the credit rating differential between the rate achieved with the financial guarantee in place and without it.⁵¹

The GE case stands for the proposition that a spread approach may be an appropriate valuation methodology for financial guarantees under certain circumstances. GE was able to charge a fee equal to the difference in percentage rates that would be charged with and without guarantees. This valuation approach is similar to the one suggested by the Australian Tax Office.

In light of the GE case and ATO Paper, the Service should provide guidance with respect to the use of a spread approach with respect to valuing financial guarantees.

² Although the participants on the project might have clients affected by the rules applicable to the subject matter of this paper and may have advised such clients on applicable law, no such participant has been specifically engaged by a client to participate in this project.

³ Treas. Reg. § 1.482-9(b)(3)(ii).

⁴ All Section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated there under unless otherwise provided.

⁵ Treas. Reg. § 1.482-2(b)(1) and Treas. Reg. § 1.482-9.

⁶Commissioner v. First Security Bank, 405 U.S. 394, 400 (1972); W. Braun Co. v. Commissioner, 396 F.2d 264, 266 (2d Cir. 1968), revg. and remanding T.C. Memo. 1967-66; Treas. Reg. § 1.482-1(b)(1).

⁷ Treas. Reg. § 1.482-9(l) (controlled services transaction).

⁸ Treas. Reg. § 1.482-2(b)(1). This regulation is generally applicable to tax years beginning before January 1, 2007.

⁹ Treas. Reg. § 1.482-2(b)(2), Example 2.

¹⁰ Treas. Reg. § 1.482-2(b)(3).

¹¹Id.

¹²Id.

¹³ Treas. Reg. § 1.482-2(b)(7)(i)-(iv).

¹⁴ Treas. Reg. § 1.482-9.

¹⁵ Treas. Reg. § 1.482-9(a).

¹⁶ Treas. Reg. § 1.482-9(b)(1).

¹⁷ Treas. Reg. § 1.482-9(b)(2).

¹⁸ Treas. Reg. § 1.482-9(b)(4)(i).

¹⁹ Treas. Reg. § 1.482-9(b)(4)(ii).

²⁰ Treas. Reg. § 1.482-9(b)(3)(ii)(H).

²¹ 92 T.C. 612 (1989), affd. 920 F.2d 1335 (7th Cir. 1990).

²²Id. at 616.

²³Id.

²⁴Id, at 617-619.

²⁵Id., at 626.

²⁶Id., at 633.

²⁷ LEXSTAT 2010 TNT 32-9 , 134 T.C. No. 5, (Feb. 18, 2010)..

²⁸ ATO Paper, ¶ 83.

²⁹ ATO Paper, ¶ 53.

³⁰ It is important to point out that the term "passive association" does not necessarily mean an "implicit credit support" arrangement. A credit support obtained as an incidental benefit from the taxpayer's passive affiliation with the multinational group is an example of passive association. However, a letter of comfort or similar statement of intent, which does not rise to the level of a formal legal agreement, does not constitute passive activity on the part of the parent company but yet falls within the category of an "implicit credit support" arrangement.

³¹ Treas. Reg. § 1.482-9(l)(1).

³² Treas. Reg. § 1.482-9(l)(3)(i).

³³ Treas. Reg. § 1.482-9(l)(3)(ii).

³⁴Id.

³⁵ Treas. Reg. § 1.482-9(l)(3)(v).

³⁶ Treas. Reg. § 1.482-9(l)(5), Example 15.

³⁷ OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration (Paris: OECD Publishing, 1995), as supplemented through 2001.

³⁸ ATO Paper, ¶ 53.

³⁹ ATO Paper, ¶¶ 109-110.

⁴⁰ Treas. Reg. § 1.482-9(l)(5), Example 16.

⁴¹ Treas. Reg. § 1.482-9(l)(5), Example 17.

⁴² ATO Paper, ¶ 123.

⁴³ Treas. Reg. § 1.482-9(l)(5), Example 18.

⁴⁴ ATO Paper, ¶¶ 121-122.

⁴⁵ ATO Paper, ¶ 128.

⁴⁶ ATO Paper, ¶ 154.

⁴⁷ ATO Paper, ¶¶ 155-156.

⁴⁸ 2009 TCC 563 (Dec. 4, 2009).

⁴⁹Id. at ¶¶ 62-65.

⁵⁰Id., at ¶¶ 71-72.

⁵¹Id., at ¶¶ 252-253, 304.