Financial Guarantees: Why You Should Give Up Rules of Thumb+
Related party financial guarantees are commonly used to provide credit support to an affiliate. Such financial guarantee may enable an affiliate to secure access to credit, to borrow at a lower interest rate, improved terms and conditions, etc. As defined by the OECD, “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.” From a legal perspective, a financial guarantee agreement has two essential elements, namely a guarantee against the borrower and an obligation of the guarantor to pay a specified sum in the event of the borrower's default. In recent years, French tax authorities started paying particular attention, during their audit, to the existence of any explicit financial guarantees, their financial consequences, the guarantee fee charged, and the justification provided by both the guarantor and the guaranteed entity. In this respect, any wrong qualification and assessment of guarantee fee could result in an increased risk of transfer pricing adjustments, which could subsequently lead to double taxation. While the subject of guarantees is carefully examined by tax inspectors during audits, there are still no specific legislation or administrative guidelines on the pricing of guarantee fee. The French Administrative Supreme Court (Conseil d’État) established a case-by-case approach without, however, clearly defining a method for assessing whether a guarantee fee should be charged and, if any, how to accurately price such guarantee fee. Let’s take a quick step back. In a decision dated 17 February 1992 (French Administrative Supreme Court, 17 February 1992, n° 81690-82782, Carrefour), the facts were the following: Carrefour SA had granted several guarantees free of charge for loans contracted by subsidiaries based in Belgium, Spain and Italy, with local financial institutions. The French tax authorities then proceeded to a tax adjustment, applying an annual fee equal to 1% of the guaranteed amounts. After recalling the principle according to which the fact that a company provides its guarantee free of charge to a third party constitutes, as a general rule, an abnormal act of management, the French Administrative Supreme Court confirmed the existence of an indirect transfer of profits. Nevertheless, it also took into account the low risk inherent in Carrefour SA's guarantee commitments to reduce this fee to 0.25%. However, this guarantee fee was not supported by any detailed economic analysis. Since then, French tax authorities have sometimes resorted to a 25 basis points guarantee fee. For instance, in the Bouygues Case, the French tax authorities has analyzed the counter-guarantee commitments, by which a French company provided its guarantee to banks that had themselves guaranteed its subsidiaries, as a guarantee corresponding to a service that should give rise to an arm’s length compensation (Versailles Administrative Court of Appeal, 11 May 2021, n°19VE02488, Bouygues; French Administrative Supreme Court, 18 February 2022, n°454483, Bouygues). The French tax authorities then applied a guarantee fee of 0.25%. The Administrative Court of Appeal states that the reference used by the French tax authorities concerns mass-market retail industry during a period whose historical economic conditions bear no relation to the conditions in force during the FY under review. Based on the analysis produced by the taxpayer and the criticism of the French tax authorities, a guarantee fee of 0.15% should have been applied. In practice, the application of the arm’s length principle to a financial guarantee agreement primarily consists of identifying the economically relevant characteristics of the transaction that may influence independent enterprises in their negotiations. In this respect, the following six factors should be included in the analysis: ● The contractual terms of the financial guarantee (including terms and conditions of the guaranteed instrument), as supported by the conduct of the parties;● The credit risk profile of the borrower, taking into account the impact of any implicit support;● The credit risk profile and financial capacity of the guarantor;● The characteristics of the financial guarantee (including benefits provided by the financial guarantee);●The economic circumstances of both the guarantor and the guaranteed entity and of the market(s) in which they operate; and● The business strategies pursued by the guarantor and guaranteed entity. Once the complete delineation of the explicit guarantee and the credit rating analysis is achieved, each of the available methods (e.g., yield approach, credit default swap approach, actuarial method) should be considered for the pricing of the guarantee fee. Considering the complexity of the issues and the critical view of the tax authorities, it is advisable to use at least two methods. In sum, given that the value of a financial guarantee increases with the amount of the financial instrument, the time to maturity as well as the underlying credit risk, any simplified approach may trigger an under or overvaluation of the guarantee fee. If, in the past, rules of thumb had sometimes been used, the degree of requirement has increased. Each step of the legal, financial and transfer pricing analysis must be strongly supported by objective, reliable and transparent data, consistent with the fact pattern of each financial guarantee.