Corporate Guarantee (CG) – TransferPricing aspects
In light of the recent Mumbai Tribunal ruling – Macrotech Developers (Lodha ), the below post explores the technical aspects on CG
OECD Guidelines states a legally binding commitment by guarantor (explicit guarantee) for the obligation of its associatedenterprise (AE) is relevant for TP analysis. Any implicit support (being a member of the Group) does not warrant any compensation.
In the Indian context, though CG partakes the character of a service, for clarity guarantee was included in the definition of internationaltransaction via Finance Act 2012. Indian jurisprudence is divided as some rulings state CG is not an international transaction, but of late Tax Tribunals (ITAT) opine otherwise. Unless proved that CG is a shareholding activity with robust evidence, ITAT does not accept taxpayer’s claim of receipt of CG fees may not be required.
It is noticed that Taxpayers initially contend that CG is not an international transaction, and when litigated by tax authorities’, Taxpayers resort to relying on certain rulings such as Everest Kanto where ITAT has accepted ALP CG fees around 0.5%.
Above is an easy reactive stop-gap approach to minimise adjustment but may not be the correct TP approach, since CG fee in ITAT rulings is based on facts specific to the taxpayer for which the ruling was pronounced and most likely facts will be different from that of the Company. Instead, Companies should proactively undertake benchmarking for CG fees, based on detailed transactional analysis. Hence, Companies should consider adopting an appropriate benchmarking analysis for arriving at the ALP of CG fees. One could adopt any of the below 5 approaches to price CG.:
- CUP Method- Fees charged by independent guarantors for guaranteeing comparable loans,
- Yield: Spread between interest rates of unguaranteed and guaranteed loans,
- Cost: Value of additional risk to guarantor due to guarantee provided – computed through option pricing, credit default swaps
- Expected loss: Calculating probability of default and adjusting for expected recovery rate
- Capital support: Computing differential capital to make credit rating of borrower and guarantor equal. Computing expected return on such notional additional capital
Robust benchmarking study increases the probability of tax authorities not disputing the issue – providing certainty and also reduces the burden on resources due to tax litigation. This is also seen in the aforesaid ruling, where ITAT overruled DRP directions that relied on judicial precedence of 0.5% as CG fees and upheld the benchmarking undertaken by the taxpayer – 0.35% as CG fees.
Further as base rates for loans are moving from LIBOR to ARR, it is vital that Companies relook at pricing policy for intragroup CG fees, to be aligned with latest industry best practices and also from a TP perspective.