As financing conditions continue to tighten, the use of financial guarantees between group companies has become an especially relevant solution. Given the scope of the guarantor’s commitments and the benefits derived by the borrower, the provision of a financial guarantee should, in principle, be remunerated at arm’s length. This remuneration typically takes the form of a guarantee fee, expressed as a percentage of the guaranteed nominal amount.
In practice, however, determining an arm’s length guarantee fee remains a complex and technical process. A recurring stumbling block is whether to distinguish the implicit support enjoyed by a borrower from the effects of the financial guarantee itself. How can these two concepts be practically reconciled without causing confusion, which could lead to tax risks?
Below, we clarify the notion of implicit support, the scope of a financial guarantee, and the implications of implicit support on the remuneration of the guarantee.
1. Assessing Potential Implicit Support
Evaluating the credit risk of both the borrower and the guarantor is a fundamental step in financial guarantees. On the one hand, assessing the borrower’s credit risk—expressed as a credit rating and taking into account potential implicit support—allows for an evaluation of the risk borne by the guarantor. On the other, the guarantor’s credit rating is equally important, both for estimating its ability to meet obligations in the event of borrower default and for applying certain methods of calculating the guarantee fee.
In this context, measuring any implicit support—that is, the likelihood of support for the borrower arising solely from its membership in a corporate group in times of financial difficulty—is a key point in the analysis of financial guarantees. In principle, this ancillary benefit, which stems only from group membership (known as passive association), does not need to be remunerated.
To assess the existence and effects of implicit support on a borrower’s stand-alone credit profile (i.e., the rating it would receive without any potential group support), each rating agency offers its own analytical framework. However, certain common assessment criteria can be identified, such as:● The degree of connection between the company’s activities and those of the group;● The company’s strategic importance;● The potential consequences of the company’s default on the group; and● Any past instances of support intervention.
French tax authorities ensure that companies’ credit risk analyses include justification for the existence of any implicit support and the measurement of its effects on the borrower’s credit rating.
2. Assessing the Legal Scope of the Financial Guarantee
The first step in the analysis is to confirm both the binding nature of the guarantee and the extent of the guarantor’s obligations in the event of borrower default. If the guarantee is a legally binding commitment by the guarantor—such as a cautionnement or a first-demand guarantee—it is referred to as an “explicit” financial guarantee.
Conversely, if the financial guarantee (e.g., a comfort letter) lacks explicit acceptance of the borrower’s payment default risk, it may provide the borrower with no additional benefit beyond that derived from its group membership. In such cases, no guarantee fee should be paid.
3. Reconciling Implicit Support and Financial Guarantees
The guarantee fee should only remunerate the guarantor’s explicit additional commitment to meet the borrower’s obligations in the event of default, beyond any benefit the borrower would enjoy without a binding commitment.
At the same time, French tax authorities may challenge the amount or even the validity of a guarantee fee if the financial guarantee does not provide the borrower with any advantage beyond the implicit support it already enjoys from other group members.
Therefore, when remunerating a financial guarantee, companies must ensure that:● The guarantee is legally binding on the guarantor;● It provides the borrower with one or more economic benefits exceeding the potential implicit support it would receive without the guarantee; and● The guarantee fee only remunerates the guarantor’s explicit additional commitment in the event of borrower default.