Introduction to upstream guarantees from a German TP perspective
Banks that grant credit to MNEs or to a parent company based in a foreign (i.e. non-German) jurisdiction can require security to be provided by the subsidiaries of the parent company. These may include, for example, the pledging of assets or the assumption of joint liability for the loan. Such a guarantee is typically referred to as an upstream guarantee due to the upward direction of the guarantee from the subsidiaries to the shareholder.
The corresponding compensation, should one be required, is the transfer price, whose value or amount must be at arm’s length. The taxpayer needs to take a supporting position as to why the guarantee fee paid is at arm’s length or justify the position if no guarantee fee is charged.
German tax authorities regularly audit cross-border financial transactions. MNEs are therefore well advised to review the arm’s length nature of the guarantee arrangement in order to mitigate transfer pricing risks. This article describes the German transfer pricing (“TP”) view on upstream guarantees, making reference to the so-called German Administrative Principles on Transfer Pricing (2024) (“AP TP”), which are binding for the German tax authorities (“GTA”) when performing tax audits. Since the OECD TP Guidelines (2022) (“OECD TPG”) are annexed to and are part of the AP TP, the German perspective needs to be examined in conjunction with the OECD TPG.
Transfer pricing analysis in a nutshell
A transfer pricing analysis of the arm’s length nature of a fee for an upstream guarantee in connection with a secured loan (often a senior secured loan facility) granted by a bank (often a consortium of banks) generally considers two separate aspects, namely the appropriateness based on merit (“Does a guarantee fee need to be charged?”) and the appropriateness based on amount (“What is an appropriate charge?”).
Transfer pricing analysis based on merit: First, appropriateness according to merit, based on German and OECD TP principles, is in general a benefit test, i.e. does the guarantee of the German guarantor, typically one of many guarantors, provided to the parent (the original debtor) constitute a real benefit to the latter? The main benefit is, theoretically, improved creditworthiness for the borrowing shareholder, which is the related party beneficiary, while the bank can also be seen as a beneficiary.
The view of the German tax authorities on this topic is summarised in the AP TP (no. 3.150, ibid.):
“For the benefits of a proven increased creditworthiness of a company, a transfer price in accordance with the arm's length principle is to be applied. The benefits may result from the fact that at least one member of the multinational enterprise group assumes the obligation towards an unrelated third party to secure the payment obligations of the enterprise. This can take the form of a guarantee, a surety, a loan agreement, a letter of comfort or real collateral. A transfer price is only to be recognized if the obligor assumes an actual risk position. (...)”
As outlined above, the German perspective needs to be examined in conjunction with the OECD TPG, which suggests the following key criteria to be considered for analysis purposes [emphasis added by the authors]:
- “(…), a guarantee is a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation.” (tn. 10.155, OECD TPG).
- “The accurate delineation of financial guarantees requires initial consideration of the economic benefit arising to the borrower beyond the one that derives from passive association, (…).” (tn. 10.156, OECD TPG).
- “By providing an explicit guarantee the guarantor is exposed to additional risk as it is legally committed to pay if the borrower defaults.” (tn. 10.163, OECD TPG).
Economic benefits (see second bullet above) can be understood, for example, as an enhancement of the terms of the loan, notably the interest rate, or access to a larger loan amount.
In a typical case, an assessment should be made as to whether the implied credit rating of the (third-party) loan transaction is enhanced by the collateral and, as a result, the interest rate is lowered. Moreover, the question needs to be analysed as to why a prudent and diligent business manager of the guarantor would have provided a guarantee (to an unrelated party) without compensation. Is there an intentional offset for the parties if the guarantor receives intra-group debt and the guarantee is reflected in the interest rate of the intra-group loan?
The abovementioned key criteria should therefore be examined when analysing whether an upstream guarantee can be recognised.
Transfer pricing analysis based on the amount: Second, if the above analysis based on merit confirms the presence of a benefit or increased creditworthiness, the guarantor should be remunerated by way of a guarantee fee payable by the borrowing shareholder. The guarantee fee in absolute terms is usually a product of various factors:
- Guarantee assessment base
- Guarantee fee rate (p.a.)
- Allocation key (if multiple guarantors exist)
- Number of days of actual guarantee provided in a year divided by 360 (or 365)
One key question is how to determine the guarantee fee rate. In practice, for example, the rate can be set conceptually by using either the “expected benefit method” or the “expected cost method” or a combination of the two, with the former reflecting a lower limit and the latter an upper limit. For instance, the expected benefit method calculates the interest rate differential – the financial benefit – based on the difference in issue ratings, the latter being the difference between the borrower’s rating without the guarantee provided by the guarantors and the borrower’s rating after it is enhanced by said guarantee.
TP risks from a tax audit perspective
From the perspective of a guarantor, assuming that no guarantee fee is charged, the GTA could in the course of a local tax audit challenge the absence of a guarantee fee if an economic benefit was provided to the foreign shareholder as the original debtor. Or when a guarantee fee is charged, but the GTA disagrees with one of the parameters relevant for calculating the (absolute) guarantee fee, in particular the guarantee fee rate. The risk of an income adjustment is “multiplied” by the number of tax audit years and potentially for subsequent years as well if the same pattern of facts continues. However, under certain circumstances the absence of a guarantee fee that, at first glance, appears necessary may still be considered appropriate and potentially defended from a substantive arm’s length perspective, but this requires in-depth analysis on a case-by-case basis.
In connection with TP, proper documentation (including pattern of facts, functional and risk analysis as well as economic analysis) is required from a German compliance perspective in accordance with Section 90 (3) of the General Tax Code (AO). It is also in general recommended to conclude a written intra-group agreement governing the guarantee fee as such, in particular if multiple guarantors are involved.
If no guarantee fee was charged for financial years for which tax returns have already been submitted and the company concludes – e.g. as part of a review or in the course of preparing transfer pricing documentation – that a fee should have been paid, the company should immediately engage with their tax or legal advisors to consider if a disclosure letter to the tax authorities may be required to protect management from personal consequences and the company from penalties.
German companies engaged in upstream guarantee arrangements are therefore well advised to review the appropriateness of their TP position based on merit and/or the amount in order to ensure that the correct income has been reported in their tax returns as well as to avoid or mitigate tax audit risks.
Our KPMG Transfer Pricing Experts would be pleased to assist you with any questions you may have.
Publishing date:
27.03.2025