intra-group finance guarantees and - transfer pricingtransferpricing.com/pdf/australia_thin...

DISCUSSION PAPER

EXTERNAL JUNE 2008 UNCLASSIFIED FORMAT AUDIENCE DATE CLASSIFICATION

FILE REF: 08/7290

Intra-group finance guarantees and loans Application of Australia’s transfer pricing and thin capitalisation rules

UNCLASSIFIED For further information or questions, call Marc Simpson on 07 3213 5199

UNCLASSIFIED INTRA-GROUP FINANCE GUARANTEES & LOANS

UNCLASSIFIED PAGE 2 OF 44

Preamble

We issued draft Tax Determination TD 2007/D20 which dealt with the question: Income tax: where there is no excess debt under Division 820 of the Income Tax Assessment Act 1997 can the transfer pricing provisions apply to adjust the pricing of costs that may become debt deductions, for example, interest and guarantee fees? Our short answer was: Yes where these charges were not in themselves consistent with the arm’s length principle.

TD 2007/D20 clarifies the nature of Division 820 of the Income Tax Assessment Act 1997 (“Division 820”) as a safe harbour so that the level of debt within the safe harbour rules is protected from the transfer pricing provisions of Division 13 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936). This means that the level of debt is not subject to adjustment under the transfer pricing rules. Taxpayers and their advisers generally agree with this clarification.

It is clear from the terms of Division 820 that the Parliament intended that a taxpayer could have a debt level higher than the arm’s length amount of debt. It also seems reasonable to conclude that the Division envisaged that the additional debt would be interest bearing. However, this paper explores the scope of Division 13 where the rate of interest (or a guarantee fee) is above an arm’s length amount. For example, you can have a 3 to 1 debt to equity ratio without regard to arm’s length principles but you cannot incur grossly excessive interest charges. The critical question is whether in determining the arm’s length interest rate or guarantee fee the analysis should be based on an arm’s length amount of debt. This is a difficult question but its resolution we think rests with an understanding of the statutory purpose of both Division 820 and Division 13.

We believe that it would be contrary to the scheme of the Act to allow a shifting of profits through non-arm’s length interest rates or guarantee fees, even where the Act contemplates the possibility of non-arm’s length debt levels. Such an approach would seem to give effect to both sets of provisions having regard to the statutory framework in which they appear and their policy intent.

These difficulties arise particularly where the debt levels allowed by the thin capitalisation safe harbour are higher than would have been the case if the related parties had dealt with each other on an arm’s length basis. If they are not, then the market can provide appropriate comparables for the interest rate or guarantee fee.Where related party dealings have resulted in a non-arm’s length gearing ratio,1 it may not be possible or practical to ascertain from the market the arm’s length consideration relevant to these circumstances because the circumstances themselves may be uncommercial or unrealistic when judged against normal and ordinary business practice. Hence subsection 136AD(4) may be applicable. The application of this provision is subject to the statutory purpose of Division 13 and the principles embodied in the Associated Enterprises Articles of Australia’s double tax treaties. By necessity the application of the provision will require a reasonable postulation of what consideration independent parties would agree to in the business and economic circumstances under examination. This paper seeks to develop a rational framework that may assist taxpayers dealing with related parties to work out an appropriate interest or guarantee charge, informed by economic concepts, the nature of business and open market practices. The model envisages behaviours that are sufficiently independent to allow participants to optimise their separate economic interests. In short, the paper rests on the 1 Even if allowed for the purposes of Division 820.


proposition that the statutory protection in relation to gearing ratios does not govern the Division 13 analysis of whether the interest charged on the debt or the guarantee fees paid to secure the debt are arm’s length. To do so would subvert the statutory scheme and purpose of both the thin capitalisation provisions and Division13.

Your feedback on the suggested methodology and framework would be appreciated, particularly if you have an alternative approach for working out an arm’s length consideration in the circumstances outlined above. This paper touches on a range of other issues as well, including questions of deductibility, in respect of which your comments would also be appreciated. Introduction

1. The purpose of this paper is to facilitate consultation between the Australian Taxation Office (Tax Office) and business representatives as part of the process of developing a Tax Office view on the application of Australia’s transfer pricing rules in Division 13 of the Income Tax Assessment Act 1936 (“Division13”) and the Associated Enterprises Article of Australia’s tax treaties (“treaty Article 9”) to intra-group finance guarantees and loans.

2. This document is prepared solely for the purpose of obtaining comments from interested

parties. This is not a publication that has been approved to allow you to rely on it and therefore does not provide you with protection from either penalty or interest. Nothing in this paper is intended to commit the Tax Office to taking a particular position in any ongoing audit or other matter involving any individual taxpayer.

3. This paper is a step in a process of consultation with tax professionals and industry bodies,

with a view to providing taxpayers with a possible approach in circumstances where there are no arm’s length comparables. It also addresses the pricing of loans and guarantees where comparables are available. This paper does not consider other transfer pricing issues currently being considered by the Tax Office in the course of developing separate public rulings on related topics.

4. The Tax Office invites comments on any aspect of the paper, and in particular on those

issues that are highlighted for specific comment throughout the text. Comments are requested by 15 July 2008. We would be particularly interested in alternative methodologies or frameworks for application in circumstances where there are no arm’s length comparables.

5. This paper also makes observations about the determination of the thin capitalisation safe

harbour amount and your comments on this matter, and the legitimacy of deductions claimed, would also be appreciated.

6. The e-mail address for purposes of submitting comments is [email protected].

7. This paper is divided into four parts. Part A deals with the context of cross-border

financing strategies and how corporate lending and guarantee arrangements operate in the


mailto:[email protected]



open market. Part B discusses approaches to the setting of interest rates and guarantee fees in accordance with the arm’s length principle. This part discusses the significance of creditworthiness in that context. Part C discusses methodologies that may assist in the calculations of an arm’s length guarantee fee. Part D discusses the definition and role of creditworthiness in the context of arm’s length pricing for both finance guarantees and intra-group loans.

8. The Tax Office view on the application of Division 13 to intra-group loans is stated in

Taxation Ruling TR 92/11, “Application of the Division 13 transfer pricing provisions to loan arrangements and credit balances”. Nothing in this discussion paper is intended to be contrary to that public ruling or indicate that the Tax Office may be considering changing its views on determining an arm’s length interest rate from those stated in TR 92/11. Paragraph 83 of that public ruling indicates that creditworthiness is a factor in determining an arm’s length interest rate, but does not address how creditworthiness is determined for this purpose. Part D of this paper addresses this issue.

9. As with any transfer pricing issue, the extent of the analysis needed to address compliance

with the arm’s length principle for intra-group loans and guarantees should be judged by applying the standard of a prudent business person and having regard to the relative importance and complexity of the issue2. TR 92/11 sets out a range of factors relevant to the characterisation of funding arrangements and facts and circumstances relevant to the determination of an arm’s length consideration in relation to a loan.

10. In the context under consideration, the current gearing ratios of the related companies

(where they are within the safe harbour thin capitalisation rules) are taken as a given for the purposes of the thin capitalisation provisions (see TD 2007/D27). In other words, there is no intent to adjust those gearing ratios using the transfer pricing provisions. Nevertheless, it would be a strange outcome if the thin capitalisation safe harbour could give rise to non-arm’s length interest rates or non-arm’s length guarantee fees which would have the outcome of shifting profits contrary to the purposes of the statutory scheme. It is submitted that the statutory protection in relation to gearing ratios should not govern the Division 13 analysis of whether the interest charged on the debt or the guarantee fees paid to secure the debt are arm’s length. To do so would subvert the statutory scheme and purpose of both the thin capitalisation provisions and Division13.

11. The views expressed in this paper on the application of the arm’s length principle could

apply equally to inbound and outbound transactions and the essential elements of the arm’s length principle and the associated methodologies are relevant whether the taxpayer is a borrower, a lender, a guarantor or the beneficiary of a guarantee.

12. This paper deals with finance guarantees and loans between separate legal entities, not

dealings between parts of a single entity. The principles and views in this paper cannot necessarily be applied by analogy in a permanent establishment context. There are special considerations in determining the creditworthiness of a permanent establishment3.

2 TR 98/11 paragraphs 1.6-1.10. 3 OECD December 2006, Report on the Attribution of Profits to Permanent Establishments, OECD.


13. This paper assumes that the related party transactions are confined to the provision of a

guarantee or a loan by a parent company to a subsidiary and do not involve any wider range of transactions or relationships that give rise to additional transfer pricing issues.

Part A: Background context for cross-border funding and guarantee arrangements

14. It is essential that a company be able to fund the assets on its balance sheet and its operations in order to remain viable. The only sources available to do this are equity, earnings (including profits from asset sales) and debt. The role of equity funding is to provide funding for the business and to assume the investment risk. Accordingly, where losses are incurred they are borne by the equity participants. The lenders still have to be repaid their principal with any interest that is owing. That is a lender’s expectation when advancing funds. The nature of the lender’s risk is different from that of an investor. The lender is not expected to fund losses and is not expected to participate in financial upside if the business is extremely successful. The lender is rewarded by a return based on the time value of money and the risk of non-payment through insolvency. A lender may refuse to lend when the risk of default is too high.

15. Where the debt funding required is not available on a stand-alone basis, equity and earnings

may allow some (lower) level of borrowing, providing the overall risk profile of the business and other circumstances do not preclude the raising of debt funding. The significance of debt and equity funding in a business will vary depending on the extent to which the operations are balance sheet driven or fee based, the prospect of losses being incurred and the likely extent of such losses should they arise. In the open market it would be expected that the capital structure of a business would comprise the balance of debt and equity funding appropriate to the type of business being conducted, with sufficient equity to allow it to be competitive in terms of its cost of funds, and adequate for the market and economic outlook.

16. It is important to recognise that financial structures and operations within multinational

enterprises can be organised in a number of ways. In some cases each entity, region or business division is given responsibility and authority to manage its own cashflow and funding requirements. This would generally entail the establishment of capital structures with sufficient equity to allow independent access to the debt markets to raise the amount of debt needed by the region or division at a price that would allow them to remain competitive.

17. In other cases the financial model adopted by the multinational group involves centralised

management of balance sheet funding and working capital, with minimal equity being used by subsidiary companies. The group then supports those subsidiaries with debt funding from the parent or group treasury company, or provides guarantees, collateral, or other comfort that allows the subsidiaries to access debt funding from the market. Multinationals adopting such centralised approaches typically point to the potential to reduce their cost of funds (through, for example, borrowing on the consolidated balance sheet and managing net overdraft positions), the possible improvement in their overall access to debt funding or particular capital markets or financial products, the ability to take advantage of natural




hedges and better manage interest rate and currency risks, and improved recognition in the capital markets as reasons for such approaches.

Group treasuries can operate as a cost centre or a profit centre

18. In some cases the group operates the centralised treasury as a cost centre which charges the

various parts of the group for its funding costs and overheads. In other cases the treasury is expected to operate as a profit centre and is allowed to trade in certain instruments and within certain limits as well as, or sometimes as an adjunct to, managing group funding and liquidity and the attendant cost of funds, interest rate and currency risks.

19. Different group strategies regarding the operation of the treasury may give rise to internally

generated profits or losses which in turn can affect the profitability of the operating divisions.

20. The business outcomes being sought by the multinational group in respect of its treasury

and its operating entities will vary from case to case and taxation (both in the home jurisdiction and in the countries in which the group conducts operations) will usually be a relevant factor in the group’s consideration of its funding strategies and cross-border financing arrangements. The reasons for this are that taxation has a direct and significant bearing on the cost of debt and equity funding and because after tax rates of return are a key indicator of investment success.

21. As explained in the 1995 OECD Transfer Pricing Guidelines for Multinational Enterprises

and Tax Administrations (“the OECD Guidelines”)4, on occasions multinational enterprises may put arrangements in place to share the costs of obtaining services where there is a mutual benefit. These arrangements involve the pooling of resources and skills by the participants where the compensation intended is the expected benefits that flow from the pooling arrangement to each of those parties without separate compensation. Independent parties do enter into arrangements to share costs and risks where there is a common need from which the enterprises can mutually benefit. The OECD Guidelines explain that such arrangements are found when a group of companies with a common need for particular activities decides to centralise or undertake jointly the activities in a way that minimises costs and risks to the benefit of each participant. This analysis is relevant to cases where shared services models are implemented by a multinational group for the provision of financial services. Whether it is appropriate to regard the arrangements between the parties as constituting a cost contribution arrangement will depend on the facts and circumstances of the case. It will be particularly relevant to consider this issue in cases where the previously separate treasury functions of several subsidiaries were centralised in one entity.

Availability of debt funding depends on creditworthiness, the likelihood of parent support and market and country factors

22. Sometimes the balance sheet and earnings of subsidiaries, regional groups or business

divisions are strong enough to support the raising of debt funding in the capital markets. In

4 OECD Guidelines, paragraphs 8.3 and 8.7-8.9, OECD.


other cases some form of support will be required from the parent to enable the subsidiaries, regional groups or business divisions to obtain debt funding. The nature of the support could range from situations where the parent borrows on the strength of its balance sheet and earnings and on-lends to the subsidiary needing the funding, to security or guarantee arrangements, negative pledges, banking covenants and letters of comfort (which may be provided to the third party lender or the subsidiary company seeking to raise the funding).

23. The relative financial strength of the subsidiary, regional group or business division

compared to the multinational group as a whole will vary. In some cases the operations of a regional group are extensive, highly profitable and the cashflows are strong and the multinational group has other businesses that are struggling and limiting group profitability. Judged on a stand-alone basis the regional group may be stronger financially than the multinational group as a whole. However to take another example, if the multinational group is able to achieve its internal rate of return target with all of its businesses, and the outlook is positive for all of its operations, the group as a whole is likely to be stronger financially than any subsidiary because of the size of the group balance sheet.

24. The financial strength of a multinational group has a major impact on its credit rating

(along with other economic and market factors) and bears directly on the amount of debt it can raise and the interest rate the group is able to obtain on its debt funding.

25. The ability of a subsidiary to borrow and the interest rate that it has to pay on its

borrowings will depend on its financial strength and whether the capital markets and specific lenders see the financial fortunes of the subsidiary as being linked to those of the parent and the group as a whole. In any event major lenders and the capital markets more generally will have regard to group relationships in evaluating the credit risk they are prepared to assume in respect of any one group or industry.

26. For example, lenders may not be prepared to advance debt funding to particular industries

or businesses, or the market as a whole may consider that a particular industry has no further tolerance to debt funding. Accordingly the willingness of lenders to actually provide debt funding for the activities conducted by a subsidiary is a factor that needs to be considered in determining the ability of the subsidiary to borrow and the cost of those borrowings. It may not be sufficient that a borrower is in theory creditworthy, especially where a borrower has been refused debt funding by the market. Alternatively, a lender may be prepared to lend to a subsidiary of a major multinational, which may not be creditworthy on a strict stand-alone assessment, where the lender judges that the subsidiary is conducting activities that are core to the group’s activities and that accordingly the parent is likely to stand behind the subsidiary in the event of difficulty lest its own credit rating be adversely affected. Such lending decisions may also be affected by the relationship that the lender may have with the parent company or by the desire to create a lending relationship with the group for strategic reasons.

27. The higher the level of debt funding the more risky the borrower entity is and capital

markets will tend not to lend to an enterprise that is inadequately capitalised having regard to the risks of its business and industry. Where the enterprise has strong cashflows it may




be able to borrow but if its credit rating is below investment grade5 the interest rate it pays will be significantly higher. Ratings below investment grade are generally referred to as ‘sub-prime’ or ‘junk bond status’. The further below investment grade the exponentially higher the interest rate, assuming that lenders are still prepared to lend, which may not be the case.

28. Where the parent company is prepared to guarantee the borrowings of a subsidiary the

subsidiary will be judged to have a creditworthiness the same as or similar to that of the parent company since the borrowings are being supported by the group’s consolidated balance sheet and operations.

29. The direct provision of funding by a parent company or the giving of a guarantee allow the

group as a whole to optimise its profitability by keeping the overall cost of external debt funding to a minimum.

Transfer pricing issues that arise in respect of parent company loans and guarantees

30. The application of the arm’s length principle requires the consideration of what

independent enterprises dealing wholly independently with each other would have done in the circumstances to further their own individual economic interests. In this regard independent enterprises will consider the options available to them having regard to their respective costs and benefits. Moreover, it has been recognised that transfer pricing distortions may be caused by the cashflow requirements of enterprises within a multinational group6. Accordingly, tax managers within multinational enterprises, their tax advisers and tax administrations need to have regard to jurisdictional and entity level issues to ensure that they are not overlooked when multinational groups implement highly integrated or centralised strategies that are driven by considerations of what is best for the group as a whole.7

31. Secondly, in applying the arm’s length principle in the context of transfer pricing

provisions in the tax law, the fact that the market may analyse the financial arrangements on a group basis may not be determinative since such an approach may defeat the purpose of the statutory rules. However, incidental benefits from association with a larger group where the market accords those benefits without an associated company actually providing an economic service that confers a benefit on the recipient would not usually be a basis for imposing a charge.

5 Investment grade is BBB- or above according to the Standard and Poors ratings system and Baa3 or above according to the Moodys rating system. 6 OECD Guidelines, paragraph 1.4, OECD. 7 Care needs to be taken in examining the transfer pricing implications of interest and guarantee charges, especially where the relevant company’s gearing ratio is within the thin capitalisation rules. Where the gearing ratios do not make commercial sense, it may be inappropriate to look for comparables without first putting the balance sheet on an arm’s length basis for this (Division 13) purpose. For Division 820 purposes there is no change to the actual debt levels .



32. A parent company has the option of funding its offshore investment directly with a mix of debt and equity. In this case the funding is supported by the balance sheet and operations of the parent and the group as a whole, enabling it to raise the debt funding its subsidiary needs. The debt cost in those circumstances would be aligned with the weighted average cost of debt and creditworthiness of the parent or the group as a whole. Such an approach raises transfer pricing issues regarding the price at which the funds are on-lent to the subsidiary. An alternative strategy would be to allow the offshore subsidiary to borrow from the banks and the capital markets. This can have the advantage of producing a natural hedge where the subsidiary borrows in the same currency as it derives its revenues. However, where the subsidiary is not financially strong enough to raise the debt funding it needs (for example, where it is highly leveraged) or would pay a higher rate of interest than the parent, it makes commercial sense to provide a guarantee to limit the external cost of funds to the best interest rate the multinational group can obtain. Where such a guarantee or other financial support is provided the transfer pricing issues include a consideration of the relationship between the members of the group involved in the guarantee arrangement and the costs and benefits accruing to each, the circumstances in which the need for the guarantee or other support arises, whether it is appropriate to charge a fee for the guarantee or other support and, if so, the pricing of the guarantee or other accommodation.

33. Multinational enterprises may have an incentive from a managerial point of view to use

arm’s length prices to be able to judge the real performance of operating divisions. Accordingly special attention is needed where arrangements produce internally generated profits in one centre that seem to distort the operating performance of other centres when the economic substance of the arrangements is considered. It also needs to be acknowledged in the context of treasury operations that transfer pricing distortions may be caused by the cashflow requirements of enterprises within the multinational group or by highly centralised approaches to cashflow management that are designed to optimise the overall financial position of the group but may disregard jurisdictional issues.

Interaction of Australia’s transfer pricing rules and thin capitalisation provisions

34. The thin capitalisation provisions in Division 820 apply to limit “debt deductions” (eg. loan

interest and guarantee fee expenses) by reference to the quantum of debt and equity of an entity. As explained in TD 2007/D20, the transfer pricing rules should not be applied to defeat the operation of Division 820 in determining what debt levels are excessive for the purpose of disallowing debt deductions on that excess debt. However, as also explained in TD 2007/D20, Division 820 does not prevent the application of the transfer pricing rules where the pricing of an intra-group loan, such as the interest rate or an amount directly incurred by the Australian borrower for the provision of a guarantee to obtain or maintain the loan, is not arm’s length8.

8 TR 2003/1, paragraphs 91-93 and TR 2005/11 (which deals with bank branches), paragraphs 40-41.


Taking account of credit support from associates - distinction between the arm’s length debt test in the thin capitalisation provisions and the arm’s length principle under the transfer pricing rules

35. The arm's length debt test is one of the tests available to a taxpayer for determining its

maximum allowable debt for the purposes of Division 820. In order to apply this test, it is necessary to identify and isolate an entity's commercial activities in connection with Australia (the Australian business). The test will be satisfied where, considering the borrower's financial and economic circumstances:

(i) the entity's adjusted debt is no greater than the amount of debt that the Australian business would reasonably be expected to have; and

(ii) the funds would have been provided to the Australian business as a loan (or a series of loans) by independent commercial lending institutions on arm's length terms.

36. The objective of the analysis is to establish an arm's length notional amount of debt that the

entity's Australian business would reasonably be expected to be able to borrow and be lent. In conducting this analysis, for entities that are not approved deposit-taking institutions (non ADIs), the arm's length debt test requires the assumption that the taxpayer is taken to be an independent entity that finances its Australian operations without financial or credit support services being provided by its associates.

37. On the other hand, when determining the pricing of the interest rate or a guarantee the

existence of credit support will be relevant if, for example, it would be relevant to arm's length parties entering into comparable dealings. This is acknowledged in the Explanatory Memorandum to the New Business Tax System (Thin Capitalisation) Bill 2001 where at paragraph 10.25, it states "prudent commercial lenders usually look at the consolidated financial position of the group to which the borrower belongs and the resources on which it could draw within that group to fund interest charges and capital repayments."

38. Paragraph 10.25 of the Explanatory Memorandum then refers to the necessary factual

assumption by stating that when applying the arm's length debt test for the purposes of Division 820:

“it is necessary to limit the extent to which the wider group is taken into account by specifying that relationships with associates that are not part of the Australian operations are to be disregarded. Any credit support from the non-Australian business operations of the entity is to be disregarded.”

39. This factual assumption and the others stipulated for the purposes of determining the ‘arm’s length debt amount’ for the various parts of Division 820 exist to ensure the test focuses only on the actual funding of the business or businesses conducted in Australia.

40. In contrast, when considering how the arm's length principle applies to the price for the

supply of debt or a guarantee from the perspective of transfer pricing rules more generally, the respective parties and tax administrators need to consider the full extent of each entity’s separate economic interests and the commercial and financial relationships that actually




operate between the entities, including the existence of any guarantee, security or other form of credit support.

41. In relation to guarantee fees, it is noted that the definition of ‘debt deduction’ in section

820-40 includes, in addition to interest and amounts in the nature of interest, any expenses directly incurred in ‘obtaining or maintaining’ the debt funding. Where a guarantee fee is otherwise deductible9 and meets this nexus test it falls within the class of debt deductions that are subject to the overall limits contained in the thin capitalisation provisions and its deductibility may thereby be affected.

Interaction of Australia’s transfer pricing rules with deduction and general anti-avoidance provisions

42. Before considering the application of the thin capitalisation or transfer pricing rules, regard

has to be had to the general deduction provisions. Where interest on a loan or the cost of a guarantee is properly a loss or outgoing of a capital nature it is not deductible under section 8-1 of the Income Tax Assessment Act 1997.

43. Where a loan is provided to a company that is unable to borrow on a stand-alone basis,

having regard to the fullest assessment of its profit potential on the basis of all the information available, even on deferred interest terms, a question may arise as to the purpose(s) of the loan and the economic substance of the arrangement between the parties. This needs to be determined objectively having regard to the facts and circumstances of the particular case. The question of whether interest deductions are or are not allowable under section 8-1 requires an examination of what the debt funding was intended to achieve from the perspectives of the profit earning structure of the borrower’s business, including shareholder interests, and the operations by which it makes its profits. (Compare Sun Newspapers10.)

44. In a case where a subsidiary could not borrow on a stand-alone basis, depending on the

facts and circumstances, it may be open to argument on the basis of the reasoning of Allsop J in the St George Bank Case11 that, at least to some extent, the debt funding is performing the role of equity. This inability to borrow may in turn have implications for the application of Accounting Concepts and Standards which require recording in financial statements to have regard to economic substance. Accordingly, to the extent that the debt is fulfilling the role of equity it might be open to argue that the interest expense attaching to the loan should be treated as being of a capital nature, at least for the period that the thinly

9 Paragraph 820-40(1)(b) requires that a cost be deductible apart from Division 820 in order for it to be a ‘debt deduction’. 10 Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 61 CLR 337. 11 St George Bank Limited v Commissioner of Taxation [2008] FCA 453

Comments are invited on any further issues raised by this paper relating to the interaction of the transfer pricing rules and thin capitalisation provisions over and above any issues raised in relation to TD 2007/D20.



capitalised structure remains in place. (From a practical perspective, while the equity level continues to be thin relative to the asset base the debt funding cannot be withdrawn without causing an insolvency and in the absence of sufficient equity losses would be likely to be borne by the related-party lenders.)

45. These matters are untested in the courts. While the focus of the discussion paper is on the

interrelationship of the transfer pricing and thin capitalisation provisions, the analysis involved may in some cases prompt a question as to whether a particular interest expense is not deductible in whole or in part because it is of a capital nature.

46. A further issue arises in relation to the operation of the debt/equity provisions contained in

Division 974 of the Income Tax Assessment Act 1997. If an advance that is made in the legal form of a loan is classified as equity under Division 974 then the interest payable on that loan is not deductible12 (but the distribution may be able to be franked).

47. Where the need for a parent guarantee arises because a highly leveraged capital structure

has been imposed by a parent company in relation to the investment it has made in an offshore subsidiary, such that without the guarantee the subsidiary effectively could not borrow, or could not do so on financially competitive terms and conditions, the guarantee is an essential component supporting the capital structure of the subsidiary and is incidental to the parent’s participation as a shareholder in the Australian subsidiary. In these circumstances serious questions arise as to the deductibility under section 8-1 of any fee charged for the guarantee on the basis that the outgoing is wholly or in part capital in nature.

48. Notwithstanding the capital exclusion a deduction for a guarantee fee may be available

under section 25-25 of the Income Tax Assessment Act 1997 (although the cost may need to be spread over the period of the loan or 5 years, whichever is the shorter), provided no adjustment is warranted under Australia’s transfer pricing provisions.

49. While the Tax Office does not expect the general anti-avoidance provisions to be relevant

in the majority of cases, where a financing arrangement involving the bearing of interest expenses and/or costs in respect of a guarantee can objectively be determined to be an arrangement to create deductions that would not otherwise be available, and to have the sole or dominant purpose of avoiding income tax otherwise payable in Australia, such deductions may also be open to challenge under Part IVA of the Income Tax Assessment Act 1936. In the normal case, unless the outcome was a gross distortion, the safe harbour rules would preclude a determination that Part IVA applied. However further consideration should be given to arrangements which involve non-arm’s length fees or charges.

12 See section 26-26 of the Income Tax Assessment Act 1997.

Comments are invited on any issues raised by this paper relating to the interaction of the transfer pricing and thin capitalisation rules and deduction and anti-avoidance provisions.



Part B: Setting interest rates and guarantee fees in accordance with the arm’s length principle

50. An essential aspect of a transfer pricing analysis required in the context of cross-border financing arrangements is the need to properly establish the nature and extent of the arrangements and to consider whether the character of the transaction derives from the relationship between the parties rather than being determined by normal commercial conditions operating between two parties dealing at arm’s length with each other.13 This requires a careful analysis of the relevant facts and circumstances and an understanding of the functions performed, the assets used and the risks assumed by each of the parties to the arrangement and a comparison with what comparable independent parties in comparable circumstances would do to further their individual economic interests.

51. The focus is on determining the true nature and effect of each element of the arrangement

and the arrangement as a whole, allowing due weight to the legal form of each element, the business context in which they occur and any relationship between different elements of the arrangement. For example, an investment in an associated enterprise may be structured in the form of interest-bearing debt when, at arm’s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. Depending on the facts and circumstances of the particular case, it may be appropriate for tax administrations in applying the relevant transfer pricing provisions to regard the purpose and object of providing the funding in the form of debt, when properly viewed in the overall commercial context, as serving, from a practical and business point of view, the ends of establishing or extending a business organisation. In such circumstances it is open to argue that no interest cost would be charged ‘between independent parties dealing at arm’s length with each other’ in relation to the supply and acquisition of that funding14.15

52. The following are scenarios:

(i) A parent provides debt funding to a wholly owned group company that is unable on a stand-alone basis to borrow the debt funding it needs;

(ii) A parent or offshore associate provides debt funding to a group company that has the financial strength to be able to borrow the debt funding it needs without support from its parent company;

13 This requirement derives from the need to establish for the purposes of the Associated Enterprises Articles of Australia’s double taxation agreements that ‘conditions operate between the two enterprises in their commercial or financial relations, which differ from those which might reasonably be expected to operate between independent enterprises dealing wholly independently with each other’; and the requirement in subsections 136AD(1) to (3) of ITAA1936 that having regard to the connection between the parties or other relevant circumstances it can be concluded that the parties were not dealing at arm’s length with each other in relation to the supply or acquisition (in the present context) of funding. 14 See the definitions of ‘arm’s length consideration’ in subparagraphs 136AA(3)(c) and (d) of the Income Tax Assessment Act 1936. 15 Compare OECD Guidelines, paragraphs 1.37 and 1.38, OECD, noting that the provisions of Division 13 as affected by any relevant parts of the International Tax Agreements Act 1953 need to be applied according to their terms.


(iii) A parent company provides a guarantee to a subsidiary that is unable to borrow the funds it needs on a stand-alone basis; and

(iv) A parent company provides a guarantee to a subsidiary that is able to borrow the funds it needs on a stand-alone basis, to allow the subsidiary to access funding at the lower cost available to the parent.

The relevant general principles are as stated in guidance issued by the Tax Office and the OECD on transfer pricing, particularly those guidelines dealing with the transfer pricing aspects of intra-group services, ie. Taxation Ruling TR 1999/1 and Chapters VII and VIII of the OECD Guidelines.

53. In discussing the four scenarios two categories of credit support could be distinguished:

(a) “explicit credit support”, which is a formal legal agreement, whether a

guarantee, letter of comfort or other assurance, by which an enterprise (the “guarantor”) agrees in respect of a loan to an associated enterprise to pay to the lender any amount payable on that loan in respect of which the borrower defaults; and

(b) “implicit credit support”, which includes:

(i) a letter of comfort or similar statement of intent which does not constitute a contractually binding commitment of the type referred to at (a); and

(ii) credit support obtained as an incidental benefit from the taxpayer’s passive affiliation with the multinational group, its parent or another group member.

It may be that other credit support arrangements exist. In such cases the principles outlined in this paper would need to be applied as appropriate on the basis of the facts and circumstances of the particular case.

54. It is important to note that Scenarios (i) and (iii) are likely to include situations where independent parties dealing at arm’s length with the subsidiary company would not provide a loan or a guarantee. In such situations it is likely that it will not be possible or practicable to ascertain the arm’s length consideration for the loan or guarantee. Where this is the case regard will have to be had to subsection 136AD(4) which allows the Commissioner to determine the arm’s length consideration. The application of this provision has to have regard to the statutory purpose of Division 13 and the principles embodied in the Associated Enterprises Articles of Australia’s double tax treaties. By necessity the application of the provision will require a reasonable postulation of what consideration independent parties would agree to in the business and economic circumstances under examination if the elements dictated by the non-arm’s length relationship were modified to allow a comparison with what independent parties would do. Such a postulation in the context of subsection 136AD(4) entails an estimate or an approximation process, informed by economic concepts, the nature of business and open market practices, and envisaging



behaviours that are sufficiently independent to allow participants to optimise their separate economic interests.

Scenario (i): offshore parent providing debt funding to a wholly owned group company that is unable to borrow on a stand-alone basis

55. As discussed above, the provision of debt funding by a parent to a wholly owned subsidiary

that is not creditworthy, that is, it is unable because of its economic circumstances to borrow the funding it needs from independent parties, brings into question the real purpose and effect of the arrangements between the parties. The arrangement cannot be explained by reference to ordinary commercial dealing between independent parties that are dealing wholly independently with each other as lender and borrower. Accordingly it is unlikely that direct reference could be made to a transaction that would be a reliable benchmark for the appropriate interest charge. Hence we may be in a situation where subsection 136AD(4) applies.

56. Judged by reference to independent dealings in comparable circumstances between

independent parties, the required debt funding would not be provided and the borrower would have to raise more equity and borrow a lesser amount. Alternatively the lender may be prepared to assume a higher level of risk in respect of part of the funding in return for a commensurate equity interest, assuming the investment is otherwise attractive.

57. Based on arm’s length principles it would be reasonable to postulate in the context of

subsection 136AD(4) that the level of equity required will depend on the nature of the activities being conducted and the amount needed to ensure that the subsidiary is competitive on a stand-alone basis. At a conceptual level the amount of equity needed for a going concern would need to be sufficient to cover the risk of losses in a particular industry and to provide the amount of additional funding that, added to the debt funding that could be raised, would fully fund the assets on the balance sheet. The total funding would have to be sufficient to obtain ownership of (or create) the necessary assets and conduct the business operations. The income would need to be able to service the working capital needs and provide appropriate rewards for the owners, subject to economic and market cycles – and the funding costs would need to be such as to allow the business to achieve these objectives. Implicit in this is that each entity’s business decision making needs to be undertaken with a view to remaining competitive and viable within its industry (whether or not that transpires to be the case). The capital structures of independent enterprises carrying on business in the particular industry would seem to be a reasonable guide to the level of equity needed for viability. Regulatory requirements in the banking and insurance sectors would also be relevant.

58. To the extent that the debt funding performs the role of an equity contribution it would

seem appropriate, based on the reasoning in TR 92/11 and paragraph 1.37 of the OECD Guidelines, that for the purposes of applying subsection 136AD(4) that portion of the debt funding be regarded as quasi equity and that it be costed on an interest-free basis, consistent with its purpose and effect. This is in line with the OECD view that the cost of funding a company’s participation is a ‘shareholder activity' and that it would not justify a charge to the borrowing company. It is clear in such a case that the parent is assuming a higher level



of risk than an independent lender would be prepared to take and would need as a practical matter to subordinate its position as lender to the claims of third party creditors. However, since it is entitled to the full equity return, it is arguable that risk is being appropriately rewarded, even where the ‘quasi equity’ funding carries no interest charge, because any increased profitability from the use of the additional funding accrues to it as owner and, depending on the funding needs of the subsidiary, can be paid out as dividends at the parent company’s direction. Any interest paid on debt funding performing the role of quasi equity could arguably be taken into account as part of the reward for the assumption of the higher level of risk than the risk a lender would assume. As such, in the context of applying subsection 136AD(4), it would not be classified as part of an independent lender’s reward were that lender acting on an arm’s length basis in its dealings with the borrower.

59. The analysis can be explored through an example where an Australian subsidiary that is an

industrial company has a balance sheet of $400 million in assets that is funded by its foreign parent with $300 million of debt and $100 million of equity. The debt funding is provided unsecured at an interest rate of 15% compared with 10% being paid by the parent on the $400 million it borrowed to make the $100 million investment in the subsidiary and also provide the $300 million loan. The 15% rate is based on the junk bond or sub-prime status of the subsidiary that is caused by its weak debt:equity ratio. The interest expense each year is accordingly $45 million for the Australian subsidiary. The capital structure of the Australian subsidiary is within the 3:1 safe harbour debt:equity test in Division 820 but the capital structure leaves the subsidiary in a position where it is not creditworthy on a stand-alone basis.

60. So, the question then arises that if the subsidiary could not borrow $300 million from

independent lenders, what is its tolerance to debt funding having regard to its assets of $400 million, its equity of $100 million and its current profitability and cashflow? Market and wider economic and country factors will also be relevant. If we assume that having regard to all the relevant criteria the subsidiary could borrow $100 million from independent lenders at 12%, that would still leave $200 million needed to fund the balance sheet of $400 million, assuming the cashflow from the subsidiary’s business operations was sufficient to meet its working capital requirements and service the debt obligations on the $100 million loan.

61. As an independent entity dealing with other independent parties in the capital markets the

subsidiary is not able to raise the full amount of the additional $200 million as debt funding. However it is able to raise $90 million from independent parties at 12% interest on the basis that $110 million of equity is raised. The market does not rate the subsidiary as creditworthy for any higher amount given the total borrowings of $100 million plus the additional $90 million needs to be serviced from the same underlying cashflow.

62. It follows in this example that $110 million of the debt funding that the parent has provided

could not have been raised as debt in the open market in dealings between independent parties dealing wholly independently with each other having regard to the economic circumstances of the subsidiary (including its assets, shareholders’ funds, earnings and cashflow, and the other risk, market and economic factors taken into account by independent lenders). While the $110 million is in form part of a loan from the parent it is




comparable to equity funding and serves that purpose when, in applying subsection 136AD(4) it is judged by reference to the outcomes it achieves and the behaviour of independent parties in comparable circumstances dealing at arm’s length with each other.

63. On this basis the interest cost (or the consideration payable for the provision of debt

funding determined under subsection 136AD(4)) is unlikely to have exceeded 12% of $190 million, $22.8 million, if the dealings had occurred between independent parties dealing at arm’s length with each other. The actual interest expense incurred was $45 million.

64. It is clear from the terms of Division 820 that the Parliament intended that a taxpayer could

have a debt level higher than the arm’s length amount of debt. It also seems reasonable to conclude that the Division envisaged that the additional debt would be interest bearing.

65. A difficult question then arises as to what consideration should be given to the policy

reflected in Division 820 when considering the power to make an adjustment to transfer prices under the Associated Enterprises Article of any relevant double tax agreement and Division 13.

66. It is clear from paragraph 820-40(1) (b) and the mechanics of the thin capitalisation rules

that Division 820 does not impinge upon the operation of the transfer pricing provisions in relation to the pricing of the debt. The consideration is determined in accordance with Division 13. The critical question is whether in that context it should be based on an arm’s length amount of debt.16

67. The difference that Division 820 makes is that it allows an amount of debt above the arm’s

length amount where the permissible safe harbour amount exceeds the amount that the taxpayer would or could have borrowed if it were an independent entity dealing wholly independently with lenders.

68. While still not free from difficulty it may be open to conclude that, in order to give effect to

both sets of provisions having regard to the statutory framework in which they appear and the policies behind each set of provisions, the taxpayer in the above example would be entitled to an interest deduction of $36 million, 12% of $300 million, resulting in the disallowance of $9 million of the claimed interest expense.

69. The final question in relation to Scenario (i) is to consider the matter of implicit credit

support obtained through passive affiliation with a larger multinational group.

70. When considering whether to make a loan to a subsidiary of a multinational, market participants will generally consider the creditworthiness of the subsidiary on a pure stand-alone basis. Once a credit rating is determined, and it is lower than the credit rating of the multinational group as a whole, the lender may then ‘notch up’ the rating on the basis of the affiliation of the subsidiary with the wider multinational group. This happens as a matter of industry practice notwithstanding the absence of any further formal financial support,

16 In this regard it needs to be noted that in some circumstances where the statutory safe harbour in Division 820

is adopted there may be no arm’s length rate if the level of debt would make the borrower uncreditworthy.



accommodation or binding assurance from the parent company. Technically the lender has no further redress beyond the assets and income of the subsidiary. However, in some cases the lender determines that having regard to the nature of the subsidiary’s operations it is likely that the parent will see those operations as core or strategic and will stand behind the subsidiary in the event of financial difficulty. Lenders will also assess other factors like strength of management in a particular field and see a borrower as less risky if it can draw on the expertise of the group.

71. Based on discussions with market participants this notching of an entity may extend from 1

to 9 notches above the initial stand-alone rating and becomes the basis on which the bank lends to the subsidiary. Even where the subsidiary is undercapitalised and has a low credit rating the market may increase the credit rating and allow a lower rate of interest.

72. None of the factors taken into account by the market in notching up the credit rating of a

subsidiary entail the assumption of additional risk by the parent or the provision of any service to the subsidiary.

73. Where the lender sees the operations of the subsidiary as discrete from the core business of

the group, or peripheral, such that it is less likely that the group will support the subsidiary in the event of difficulty, it would be less likely to afford better terms and conditions for a loan than are warranted by the stand-alone assessment.

74. There has been much debate in the context of transfer pricing cases as to whether the

availability of ‘notching’ should be taken into account in determining an arm’s length interest rate. Some say that to do so would be inconsistent with the arm’s length principle embodied in the Associated Enterprises Articles of Australia’s double tax agreements and Division 13, which are based on the outcome that would be achieved by independent parties dealing wholly independently17 with each other.

75. Others argue that since the notching advantage flows from the market and not something

the parent company has done or provided the benefit to the subsidiary should be regarded as incidental and attributable solely to its being part of a larger concern and would not warrant a service charge by the parent on the subsidiary. In this regard the OECD cites the example of an associated enterprise that by reason of its affiliation alone has a credit rating higher than it would have if it were unaffiliated. Paragraph 7.13 of the OECD Guidelines states:

“Similarly, an associated enterprise should not be considered to receive an intra-group

service when it obtains incidental benefits attributable solely to its being part of a larger concern, and not to any specific activity performed. For example, no service would be received where an associated enterprise by reason of its affiliation alone has a credit-rating higher than it would if it were unaffiliated, but an intra-group service would

17 The definitions of ‘arm’s length consideration’ in paragraphs 136AA(3) (c) and (d) are framed in terms of the consideration that might reasonably be expected to be given or agreed between independent parties dealing ‘at arm’s length with each other’. However for present purposes this is not seen as creating a material difference.



usually exist where the higher credit rating were due to a guarantee by another group member…”18

There are no widely accepted objective criteria for allocating such economies or diseconomies of scale or benefits and disadvantages of integration and in such circumstances it may be appropriate to determine the outcome by reference to what the subsidiary could achieve itself through dealing directly in the open market, despite the fact that the market will pay some regard to affiliation.

76. Accordingly, if on a stand-alone basis the subsidiary had a credit rating below investment

grade which dictated an interest rate of 15% but the market was prepared to notch up the credit rating without any further financial support or binding commitment from the parent to a level that allowed the subsidiary to borrow at 12% it could be argued that the 12% interest rate represents the correct arm’s length transfer price.

Scenario (ii): A parent or offshore associate provides debt funding to a group company that has the financial strength to be able to borrow the debt funding it needs without support from its parent company

77. If in the example outlined in Scenario (i) the parent company had provided the subsidiary with sufficient equity to enable it to borrow the debt funding it needs directly from the market on terms that allow the subsidiary to be competitive and survive, one can conclude that at least in terms of its capital structure the subsidiary is financially independent of its parent. In such circumstances it is possible to have regard to the terms and conditions on which the market would be prepared to lend to the subsidiary and use those as a benchmark for any debt funding that the parent provides to the subsidiary.

78. Where a parent company provides debt funding to such a subsidiary on the best terms and

conditions that the subsidiary could obtain from independent parties in the open market (and the amount lent and borrowed is within the debt tolerance accorded by the open market) no transfer pricing issue arises. An arm’s length borrower would consider the economic options reasonably available and accordingly could be expected to accept the best terms and conditions on offer.

79. Since the subsidiary is financially viable on a ‘stand-alone’ basis the form and substance of

the dealings between the parent and the subsidiary would be that of lender and borrower and there is no question of the debt funding performing the purpose and objects of equity funding.

18 This is expressly adopted as the Tax Office position: TR 1999/1 paragraph 32.

Comments are invited on any issues raised by Scenario (i) on the application of the transfer pricing rules and thin capitalisation provisions. What do you think should be the outcome based on the example outlined in paragraph 59 above.



80. Similarly to Scenario (i) it is arguably not appropriate to adjust a market price that includes notching benefits that incidentally arise from the passive association of the subsidiary with the wider group.

Scenario (iii): A parent company provides a guarantee to a subsidiary that is unable to borrow the funds it needs on a stand-alone basis

81. For separate legal entities, Division 13 applies to a supply or acquisition of “property”,

which is defined in subsection 136AA(1) of the ITAA 1936 to include “services”. The Tax Office view is that “services” includes the provision of financial services which may include the guarantee of a loan19. A similar, consistent treatment is appropriate for the Australian version of the Associated Enterprises Article which specifically refers to the ‘conditions that operate between two enterprises in their commercial or financial relations’ which produce non-arm’s length profit outcomes.

82. It may be that a guarantee is given by a parent company to a subsidiary in circumstances

where no independent party would have provided the guarantee. In such circumstances regard would have to be had to subsection 136AD(4) in determining an arm’s length consideration for the transaction.

83. A guarantee is a legally binding commitment by the parent 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.

84. The scope of the transfer pricing review will depend on the facts and circumstances. In

particular, it will be important to establish whether the relevant ‘international agreement’ or ‘conditions that operate in the commercial or financial relations’ between the taxpayer and an associated party is/are confined to the provision of a guarantee or involve a wider combination of elements that relate to the viability and funding of the taxpayer and/or the activities of the parent as a shareholder in establishing and protecting its investment.

85. A guarantee by its nature confers a benefit on the debtor and the creditor but as a matter of

commercial practice it is unlikely that the creditor will pay for the benefit of a guarantee20. Where a lender was minded to obtain some form of insurance for the loan it would be expected that those costs would be covered by the margin or transaction costs to be met by the borrower. The benefit provided by the creditor is the provision of the debt funding to the debtor, along with the possibility that it may seek redress from the guarantor rather than pursue the defaulting debtor and cause a liquidation.

86. It is a practical necessity that a person giving a guarantee needs to have the financial

strength to support the guarantee in the event that a call is made on it by the creditor. 19 TR 94/14 paragraphs 33 and 237. 20 Vermeesch, RB and Lindgren, K E 2004, Business Law of Australia ‘11th edn’, Williams, K J, Chapter 27 Guarantee and Suretyship, LexisNexis Butterworths, Chatswood NSW.

Comments are invited on any issues raised by Scenario (ii).


Where this is not the case further examination is required to establish the nature and purpose of the arrangement and the purposes and objects being pursued by each of the parties to the arrangement. Part of this examination would involve the consideration of what difference the arrangement made to the economic circumstances of each of the participants.

87. There are aspects of the relationship between the parent and the subsidiary that need to be

taken into account. In certain circumstances the giving of a guarantee can also confer benefits on the parent giving the guarantee, who may otherwise be required to take on a more onerous financial commitment in respect of the subsidiary. For example, if the guarantee arrangement were not put in place the parent may have to increase its borrowings, pay interest and inject additional equity into the subsidiary. In addition the parent may suffer some other disadvantage or cost. For example, the parent may have to redirect internal funding or be exposed to foreign exchange risk.

88. Guarantee arrangements need to be analysed to ascertain whether and how the risks that

existed prior to the arrangement are varied in terms of their incidence by the use of a guarantee. In some cases banking covenants applicable to the parent’s debt facilities can include the default of a substantial subsidiary as an event of default that may cause the termination of the facility. In other cases the third party lender may be a prime lender to the parent company. Where the subsidiary is conducting activities that are core to the business of the group as a whole, it may not be possible for the parent to abandon a subsidiary that encounters financial difficulty without the parent suffering a credit rating downgrade. Any of these circumstances may produce the practical result that the parent and subsidiary are financially interdependent quite apart from any formal guarantee arrangement, so that the parent’s economic risk may not change materially on the giving of a formal guarantee, though clearly the legal obligation is not open to argument, especially when the guarantee is executed in the form of a deed.

89. Guarantees are an instrument by which the third party lenders lay off or abate some of their

credit risk in respect of a loan so as to make the deal attractive and, correspondingly, where borrowers avail themselves of guarantee arrangements to reduce their credit risk in order to obtain debt funding that would not otherwise be available. The guarantee is a means of risk management and the provider of the guarantee is helping the lender and borrower to manage their respective risks.

90. In the context of independent dealings it has been said that risk managers,

‘adjust the risk exposures of their clients, usually – but by no means always – downward. They may do this by absorbing the risk themselves and diversifying across clients (eg insurers may hold the insurance they write) or by transferring the risk to a third party (eg a reinsurer or counterparty in a derivatives transaction)….Recently developed derivatives that pay off on discrete events increasingly blur the distinction between insurance and other financial instruments.




Risk managers attempt to generate income by charging a premium for absorbing risk. Assuming competitive markets, this risk premium should fall with the risk manager’s ability to diversify the risk’21

91. However in the context of transfer pricing for dealings between related parties it cannot be

assumed that the giving of a finance guarantee to a subsidiary or a lender to the subsidiary would necessarily change the risk profile of the parent or entitle the parent to charge a fee when all the relevant facts and circumstances are taken into account.

92. Both TR 1999/1 and the OECD Guidelines use an “expected benefit” test in applying the

arm’s length principle to the question of whether an activity gives rise to the supply of a chargeable service. Thus, whether an activity is a chargeable service depends upon whether that activity is expected to confer a benefit on another enterprise22.

93. Regarding the concept of “expected benefit”, TR 1999/1 states23:

‘In general terms, a benefit is something of economic or commercial value that an independent entity might reasonably expect to pay for … a benefit is an economic or commercial advantage that would assist the recipient’s profitability or net worth by enhancing, assisting or improving its income production, profit making … Alternatively, a benefit could result in a reduction of the recipient’s expenses or otherwise facilitate its operations.’

94. Chapter VII of the OECD Guidelines similarly states:

‘7.6 Under the arm’s length principle, the question whether an intra-group service has been rendered when an activity is performed for one or more group members by another group member should depend on whether the activity provides a respective group member with economic or commercial value to enhance its commercial position. This can be determined by considering whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself. If the activity is not one for which the independent enterprise would have been willing to pay or perform for itself, the activity ordinarily should not be considered as an intra-group service under the arm’s length principle.’

95. Transfer pricing issues in relation to the provision of services need to be examined from the

perspective of both the provider and the recipient24. It is also important to establish the relationship between the relevant services and the activities and the performance of the various members of the multinational group25. Essentially this involves an economic and financial analysis of the context for the dealings and the functions, assets and risks involved

21 Ryan, S G 2002, Financial Instruments & Institutions: Accounting and Disclosure Rules, John Wiley & Sons, Inc, New Jersey USA, p. 14. 22 TR 1999/1 paragraph 17. 23 TR 1999/1 paragraph 18. 24 OECD Guidelines, paragraph 7.29, OECD. 25 OECD Guidelines, paragraph 7.32, OECD.


for each of the parties. As a consequence the costs and benefits for each party become apparent. It also becomes apparent whether there is a net benefit flowing in one direction or the other, or a shifting of value without adequate consideration.

96. Where the need for the guarantee stemmed from decisions made by the parent company in

relation to the capital structures it would use in its subsidiary companies, those structures provide benefits to the parent company in reducing the amount of equity and debt it needs to commit and by enhancing cashflow and tax outcomes. Where a guarantee is provided by a parent to a subsidiary that is otherwise not creditworthy, the subsequent borrowing by the subsidiary results in the incurring of the costs of that debt that would otherwise be borne by the parent if it had to provide the debt funding.

97. Equity carries a higher cost than debt because the equity investor wants a higher return for

the risk that it may lose on its investment and because debt is serviced out of pre-tax earnings and dividends are paid out of post-tax profits. Accordingly to the extent that a parent company can fund a subsidiary with debt rather than equity there is likely to be a saving in the parent’s funding costs. Debt funding brings other tax advantages in a cross-border context because interest expense is generally deductible and the rate of withholding tax is generally lower than tax rates applicable to business profits and is sometimes zero.

98. A proper cost benefit analysis which had regard to both the perspective of the guarantor and

the party obtaining the guarantee would take all the costs and benefits to each party into account. Independent parties would take all benefits into account. Where under the arrangement the level of indebtedness relative to equity funding exceeds the amount that would allow the borrower to be regarded as financially independent so as to be able to conduct its affairs on the basis of its own economic position without the need for additional support to meet its funding needs, it imposes a serious detriment on the borrower. It is highly unlikely that independent parties would be prepared to pay for such an outcome or for costs, like guarantee fees, imposed as part and parcel of such a thin capitalisation strategy where the net outcome advantages one party to the disadvantage of the other. This is the antithesis of arm’s length dealing, which has the hallmark that each party obtains commensurate benefits that allow each party to optimise its economic outcomes in the particular circumstances.

99. There is an even more basic question of whether an independent party would provide a

guarantee to support the borrowing of the company that could not borrow in its own right. The corollary is whether an independent party with insufficient tolerance to debt funding could obtain a guarantee from an independent party dealing wholly independently with the borrower. In cases of this kind it is unlikely that an arm’s length consideration will be able to be ascertained since independent comparables are unlikely to exist and recourse may be needed to subsection 136AD(4) to estimate or approximate the appropriate amount.

100. The discussion in relation to the provision of benefits in TR 1999/1 and the OECD

Guidelines assumes that the company being considered as the acquirer of a benefit is in fact an independent going concern that is in a position to acquire the assets and services it needs. It is this ability to deal independently that is essential to the application of the arm’s length principle. Where it is the very lack of independence that causes an entity to engage




in a particular transaction that would not be countenanced by independent parties that outcome will not be consistent with the arm’s length principle.

101. In such situations the non-arm’s length aspects need to be identified and consideration

given to how they could be conformed so as to be acceptable to independent parties dealing wholly independently with each other.

102. An independent company that is unable to borrow the funds it needs on a stand-alone basis

is unlikely to be in a position to obtain a guarantee from an independent party to support the borrowings it needs. Where such a guarantee is given it compensates for the inadequacies in the financial position of the borrower; specifically, the fact that the subsidiary does not have enough shareholders’ funds. In cases of this kind regard would have to be had to the provisions of subsection 136AD(4).

103. It would not be expected that a company pay for the acquisition of the equity it needs for its

formation and continued viability. Equity is generally supplied by the shareholders at their own cost and risk.

104. Accordingly to the extent that a guarantee substitutes for the investment of the equity

needed to allow a subsidiary to be self-sufficient and raise the debt funding it needs, the costs of the guarantee (and the associated risk) should remain with the parent company providing the guarantee.

105. The pricing of a guarantee is calculated as a percentage or spread on the amount of the debt

being guaranteed. No chargeable percentage or spread arises on any portion of the debt that serves the purposes of equity.

106. Quite apart from the question of whether a parent is entitled to charge a subsidiary a

guarantee, a guarantee arrangement is likely to lack economic substance where the guarantor lacks the financial capacity to meet its obligations were it required to do so. In such circumstances the purpose and objects of the arrangement need to be examined in the light of the inability of the guarantor to perform.26

107. It would not be expected that independent borrowers would pay fees for arrangements that

result in an overall detriment to them. Nor would they be expected to pay fees for benefits that are already available, whether those benefits are available on a cost-free basis or have been already purchased for full value. In such cases serious questions would arise as to the true nature and effect of the arrangements between the parties and the purpose of the arrangements.

108. In order to justify a charge for the guarantee it would have to be demonstrated that the

arrangement did not result in a net disadvantage to the subsidiary or replicate a benefit already available. Where the parent does not assume risk additional to that which it already has as shareholder before the giving of the guarantee the taxpayer would need to demonstrate the basis for any charges.

26 OECD Guidelines, paragraphs 1.26-1.27, OECD.


109. Where a subsidiary derives implicit credit support as an incidental benefit from its parental

affiliation, the benefit derives from the market, not from the provision of any service by the parent. The parent has limited its exposure to the equity it has already subscribed.

110. Depending on the facts and circumstances, it may be that a subsidiary that is not

creditworthy on a pure stand-alone analysis is able to obtain the debt funding it needs because the market is prepared to notch up the credit rating on the basis of the subsidiary’s group affiliation. For example, a subsidiary with a stand-alone credit rating of BB which would make it uncreditworthy and unable to complete in its industry may be given a credit rating of A+ by the market without any further financial support or binding commitment from the parent. No charge should be made by the parent for this benefit.

111. However, continuing the example, the parent may provide a guarantee that allows the

subsidiary to borrow at the parent’s credit rating of AA instead of the A+ rating, with a corresponding reduction in the interest rate the subsidiary would pay. The benefit the parent has provided to the subsidiary is the improvement in the credit rating from A+ to AA. On a consolidated basis this results in a saving to the group (or an increase in profit) equal to the differential between the interest rate payable by an A+ rated entity and the interest rate payable by an entity rated AA, less any transaction costs relating to the guarantee. The desire by the parent company to optimise the cost of external funding is the driver. The benefit for the group derives from the strength of its consolidated balance sheet, earnings and cashflow that justify the AA rating. It does not derive from any economic contribution by the subsidiary to the profit channel. The subsidiary’s contribution flows from the use of the borrowed funds to derive revenues, less the interest and transaction costs the subsidiary would have incurred without the guarantee.

112. Be that as it may, the giving of the guarantee exposes the parent to the full risk of default in

relation to the loan principal and interest. The reality is that the subsidiary’s economic circumstances warrant a credit rating of BB and but for its affiliation with the larger group the subsidiary would not be able to borrow the funding it needs (since it would not be creditworthy in its industry with a BB rating).

113. Nevertheless the parent has provided the guarantee in circumstances where no independent

party would have done so. Accordingly, given the absence of arm’s length benchmarks the case falls to be considered under subsection 136AD(4). The benefit to the subsidiary is the marginal saving in interest expense from being able to borrow on an AA rated basis instead of the A+ rating it would have obtained without the guarantee. This is the only benefit for which an independent borrower would be prepared to pay. Accordingly, the charge that the parent can make on the subsidiary cannot include any element for the improvement in credit rating from the pure stand-alone rating of BB to A+ since the subsidiary could have obtained this benefit on the open market without the guarantee.

114. It follows from the above analysis that if the market was prepared to allow notching from

the subsidiary’s stand-alone rating of BB even further than A+ to AA, an eight notch increase bringing the subsidiary’s rating to that of the parent, a formal guarantee would not



confer a better interest rate to that already available. Accordingly the onus would be on the taxpayer to show why a charge would be justified.

115. Guarantee arrangements are further discussed in Part C: Methodologies. 116. Independent lenders who retain some uncertainty about the attractiveness of a deal having

regard to the economic circumstances of the borrower may require the parent to provide a letter of comfort or similar statement of intent before they will agree to lend. Regard would have to be given to the existence of any letters of comfort or statements of intent in order to gauge the impact on the risk exposure of the parent company. The legal effect of such arrangements depends on the facts and circumstances. Where the wording is consistent with the language of contractual promises such statements have been held to be contractually binding. However in many cases parties providing such letters and statements studiously avoid language that will create contractual obligations. Generally speaking the market regards letters of comfort and similar statements of intent as morally rather than legally binding. Any further financial exposure would depend on the subsequent actions of the parent in actually providing additional funding in the event of a default. Such circumstances are akin to shareholder activity and not independent market dealing. This scenario raises difficult questions that would need to be considered in the context of subsection 136AD(4) and the taxpayer would need to demonstrate why a charge would be justified.

Comments are invited on any issues raised by Scenario (iii).

Scenario (iv): A parent company provides a guarantee to a subsidiary that is able to borrow the funds it needs on a stand-alone basis, to allow the subsidiary to access funding at the lower cost available to the parent

117. In a case where the member is financially viable on a stand-alone basis and has sought to

raise debt funding in its own right and the market does not perceive the parent company as having any compelling reason to assume any further financial risk in relation to the subsidiary beyond the equity it has already injected, the capital markets may, for example, credit rate the parent company as ‘AA’ and separately rate its subsidiary as ‘BBB+’ after any notching up of the subsidiary’s stand-alone rating that the market was prepared to make. In this situation the giving of an explicit guarantee by the parent would enable the subsidiary to borrow at the lower rate of interest applicable to a ‘AA’ rated corporation, or very close to that. (In some cases the ability to access a wider range of assets in the event of a default may produce a credit rating higher than that of the parent.) There would be a cost saving to the subsidiary of the difference between the interest rate applicable to BBB+ rated debt and AA rated debt. An independent party in the position of the borrower would be prepared to pay for a guarantee to achieve that outcome provided it was no worse off than it would have been if it borrowed on the open market on the basis of its credit rating of BBB+ and the fee being sought by the guarantor was competitive with other options or benchmarks in the open market. Within a multinational group there is an imperative to minimise the external cost of funds on a group-wide basis in order to optimise group



profitability and it would be expected that a subsidiary would be required to enter the guarantee arrangement to secure a lower interest rate.

118. The setting of an arm’s length guarantee fee is discussed more fully in Part C:

Methodologies. 119. Capital markets may perceive a particular multinational group as highly financially

integrated. Therefore they may not differentiate between the credit ratings they assign to individual group members. For instance, the group as a whole may be ‘AA’ rated and its individual members not separately rated, with any member having the incidental benefit of an ‘AA’ rating when it raises funds. Where the market perceives that conditions exist that would require the parent company to stand behind any subsidiary a more detailed analysis is required in order to determine whether or not some intra-group charge should be levied from a transfer pricing perspective. This will depend on a proper analysis of the reasons for the market view and a cost/benefit analysis that takes account of the perspective of each party and their respective functions, assets and risks.

120. Under the arm’s length principle, any incidental benefits that a group member obtains

through passive group or parental affiliation do not give rise to a chargeable service. In this regard, the arm’s length principle distinguishes between such implicit credit support and an explicit guarantee as discussed in paragraph 7.13 of the OECD Guidelines referred to above.

121. Instead of giving a formal letter of guarantee, a parent may provide a letter of comfort or

other statement of intent that is not intended by the issuer to constitute a legally binding commitment to repay the subsidiary’s loan in the event of a default. This intent and its non-binding nature are usually explicitly stated to the subsidiary or other recipient of the comfort letter. Issuers may also have to consider the risk to reputation or the loss of relationship with the lender. Lenders may have their own reasons for wanting to establish a lender relationship with the group and be prepared to lend on that basis. In cases where the capital markets regard such assurances as moral rather than legal undertakings it could be expected that the lender would exercise a higher level of scrutiny of the financial circumstances of the borrower, expecting that in the event of default its redress may well be limited to the borrower’s assets and income. In the final analysis the lender has advanced funds without the need for a guarantee but with the expectation that the parent will stand behind the subsidiary. It is clear that in such cases the giving of comfort does not of itself affect the financial position of the parent or the group as a whole. Any financial impact on the parent would depend on subsequent conduct by the parent in meeting the amounts in default. Such support from the parent company in staving off of an insolvency would seem to be directly related to the protection of its investment and fall within the description of a ‘shareholder activity’.

122. It follows on this analysis that the benefits of implicit support from letters of comfort or

similar non-binding statements of intent should be treated similarly to any creditworthiness benefits a subsidiary incidentally obtains from its group or parental affiliations, and the onus would be on the taxpayer to demonstrate a valid basis for any charge for the giving of a letter of comfort.




123. The principles outlined above in relation to guarantees and shareholder activity would need

to be considered in cases where a parent company provides a legally binding letter of comfort or similar undertaking.

Part C: Methodologies. How is an arm’s length charge for a chargeable finance guarantee determined?

124. In cases where on a proper analysis a finance guarantee is to be recognised and priced as a

chargeable service, the principles for determining an arm’s length charge for that service are as stated at paragraphs 58-74 of TR 1999/1 and 7.29 to 7.37 of the OECD Guidelines. In certain cases the principles set out in Chapter VIII of the OECD Guidelines, Cost contribution arrangements, will be relevant.

125. As discussed above, a key principle is that:

“In trying to determine the arm’s length price in relation to intra-group services, the matter should be considered both from the perspective of the service provider and from the perspective of the recipient of the service.”27

126. A method that approaches the issue solely from the perspective of one party may not

determine a pricing outcome that would be agreed by both parties were they independent. Moreover such a one-sided approach runs the risk of failing to properly consider contextual issues, the respective economic contributions of each of the parties and may lead to a misunderstanding of the role of the guarantee in the overall financial framework operating within the multinational group.

127. All transfer pricing methodologies are based on the concept of ‘comparability’. In practical

terms this requires a benchmarking with what independent enterprises that are comparable to the tested parties would have done in comparable circumstances in relation to comparable dealings.

128. Often a comparable uncontrolled price (CUP) or cost plus method is used to price an intra-

group service, although any of the arm’s length pricing methods as per Chapters I-III of the OECD Guidelines and Taxation Ruling TR 97/20 may be used provided the method is appropriate to the context and is the most reliable method28. Consistent with general guidance on the use of arm’s length pricing methods, a CUP method is the most appropriate method to determine an arm’s length guarantee fee where there is sufficient reliable data of fees charged for comparable guarantee arrangements in comparable circumstances between

27 OECD Guidelines, paragraph 7.29, OECD and TR 1999/1 paragraph 59. 28 TR 1999/1 paragraphs 58-59.

Comments are invited on any issues raised by Scenario (iv) and the application of the arm’s length principle to the issue of intra-group charges for implicit credit support through letters of comfort or similar arrangements.


comparable independent parties. Accordingly a guarantee arrangement cannot be analysed at a transactional level without regard to the context. The CUP method would be suitable in cases where a creditworthy subsidiary that is able to raise the debt funding it needs on a stand-alone basis obtains better terms with the benefit of a parent guarantee. A similar approach would be a benefit approach (“spread method”) under which an arm’s length fee is estimated as the spread between the interest rate the borrower would have paid without the guarantee and the rate it pays with the guarantee, less an arm’s length discount.

129. The remaining spread, net of the discount, would have to be sufficient to make the deal

attractive to an independent guarantor for the additional risk it would assume if it provided the guarantee. If there is no additional risk then consideration has to be given to the economic substance of the arrangement between the parties.

130. An independent guarantor would have regard to its potential loss in the event of default, the

circumstances in which a loss may arise and the probability of such a loss crystallising, the balance sheet and market impacts of assuming the contingency and if the loss is realised, as well as the amount and cost of capital needed to support the risk. An independent debtor or creditor is unlikely to accept a guarantee from a party with inadequate capital backing, or may be prepared to pay less for it if some additional collateral would be obtained albeit less than the debtor or creditor would have preferred. The pricing approach by an independent guarantor will be to secure a margin that is attractive relative to other economic options reasonably available to it and to optimise its margin relative to the risk assumed. For its part a borrower seeking the benefit of a guarantee would need to be in a sufficiently strong financial position such that an independent party would contemplate providing a guarantee. Moreover, an independent borrower seeking such a guarantee would evaluate all the economic options reasonably available and would select the option providing the best value in terms of improving the borrower’s economic position.

131. In cases where the guarantee is part of a set of relationships between the parent and the

subsidiary a profit split approach may be appropriate. For example, the parent may supply trading stock to a subsidiary, purchase outputs from the subsidiary and also provide debt funding and a guarantee. There may be benefits flowing from the parent to the subsidiary and also from the subsidiary to the parent. Such cases require a careful analysis of benefit flows and their impacts on the respective parties in order to appropriately determine the share of profit each party should receive for its contribution to the profit channel.

132. In complex cases a combination of methodologies may be needed.

Comments are invited on the discussion of methodologies and any other methods that might be appropriate to use in determining an arm’s length price for an intra-group finance guarantee.

Use of the CUP method

133. In considering the application of the CUP method the starting point is that the entities are truly independent of each other. Accordingly adjustments would need to be made where the



guarantee is given to a subsidiary that could not obtain a guarantee from an independent entity. It is also a prerequisite to the application of the CUP method that the situation is one in which the parent has conferred a benefit on the subsidiary for which the parent is entitled to charge.

134. The suitability of the CUP method depends on whether the relationship between the parties

can be sufficiently analysed by reference to the transaction under examination, or whether a wider context is required. Where there are other cross-border related party dealings it would be necessary to have regard to the entirety of those relationships in order to ensure that any interdependencies between the dealings or combined impacts are properly addressed in terms of whether the overall outcomes are arm’s length.

135. The CUP method benchmarks an intra-group guarantee fee against the fee charged in

comparable guarantee arrangements in comparable circumstances between comparable independent parties dealing wholly independently with each other. The CUP method requires a high degree of comparability in respect of all of the factors that might materially affect the rate of guarantee fee. These factors include the circumstances in which the guarantee is provided, the benefit(s) arising from the guarantee for each of the parties involved, the terms and conditions of the guarantee and of the underlying debt funding. The risk profiles of the borrower and the guarantor would also be relevant (for which their scale of operations, assets, earnings before interest and tax (EBIT), cashflows and creditworthiness may be a suitable proxy and provide a basis for identifying their relative financial strengths).

136. While in theory the CUP method is the most reliable for determining an arm’s length

guarantee fee, its use requires data to support the analysis of the different elements of comparability, which in practice may be difficult to obtain, or may not exist. Its suitability as a methodology becomes questionable when the financial relations between a parent and its subsidiary are not arm’s length and it is that very circumstance that gives rise to the need for a guarantee. Unless appropriate adjustments can be made to improve comparability another methodology may give more reliable results.

137. Guarantees may support the raising of debt funding generally or be confined to particular

loans or facilities.

138. An independent party in the position of a lender or a borrower would accept a guarantee only if the provider had the financial strength to support the guarantee in the event of a default.

139. The nature of the risk to the guarantor is linked to the underlying transaction that may give

rise to the invocation of the guarantee.

140. Guarantees would generally come into effect in the event of a failure to pay interest or principal according to the agreed timetable, or a failure to perform other obligations. It is not a condition precedent that the creditor sue the debtor or realise any security before relief can be sought from a guarantor. Creditors may have multiple remedies which they can pursue selectively or concurrently. However, guarantees may include specific provisions




that limit the redress against a guarantor to situations where the lender has exhausted its recovery options against the borrower. The market perceives advantages in guarantees that have few if any qualifications since the beneficiary is assured of payment without delay or argument.29

141. Events of default by a borrower can have several different causes including the quality of

management, the attributes of the particular business being funded (eg whether it is a start-up or an established business and the factors affecting its cost efficiency and revenue efficiency), the characteristics of the industry and wider economic or market factors.

142. The extent of the risk to the guarantor depends on the profitability and cashflow of the

subsidiary being guaranteed and the realisable value of its assets relative to the overall level of its debt funding and the extent to which lenders can call upon the guarantee. Accounting rules, including those relating to Related Party Disclosures (IAS 24), Provisions, Contingent Liabilities and Contingent Assets (IAS 37), Financial Instruments Recognition and Measurement (IAS 39) and Financial Instruments: Disclosures (IFRS 7), require the disclosure of guarantees and the notes to the accounts to explain the extent of the potential exposure. Once a liability event has occurred a guarantor is required to make provision in its accounts. In the case of large multinational enterprises the potential loss to a guarantor in respect of a group subsidiary is likely to be material.

143. Within the scope of what is reasonable in the context of an independent guarantor who

would be prepared to assume an acceptable level of risk for an appropriate reward, an independent guarantor would want to minimise the risk of claims and would have regard to what may happen in the future as well as the current financial circumstances. Whether a business is growing the size of its balance sheet or maintaining it at a constant level there will be an ongoing need for debt funding and the debt levels will be higher where the borrower continues to be thinly capitalised by its parent. It is generally accepted that the longer the debt funding is in place (whether as long term debt or refinanced on a short term basis) the greater the risk to the lender - and this will increase the risk for the guarantor.

144. Independent parties provide guarantees in circumstances where the risk involved is

considered acceptable in overall terms and the guarantor is satisfied that risk management processes are in place that will minimise the risk of default and contain its exposure should an event of default trigger its liability, leaving the guarantor in a position to optimise its profit from the guarantee arrangement. This requires an independence of commercial judgment unfettered by any other relationship interest (for example the considerations of a parent company in establishing and maintaining the capital structure of a subsidiary and funding its participation) which may impact on the ability of the guarantor to optimise its economic interests in respect of the guarantee arrangement as a stand-alone transaction. A characteristic of an independent dealing is the ability to judge the deal on its merits and either accept it or reject it. Where a guarantor cannot refuse the giving of a guarantee a question arises as to the nature and effect of the arrangement. Creditors will also have rights in the event of a default and these will limit the options available to a guarantor such

29 Op cit, Business Law of Australia, Chapter 27 Guarantee and Suretyship.


circumstances. Accordingly, the taxpayer would need to demonstrate that a charge for the guarantee was warranted.

145. Where a subsidiary has insufficient equity to be creditworthy on a stand-alone basis the

subsidiary would not be able to obtain a guarantee from an independent party since the market would regard the subsidiary as too high a risk in relation to the likelihood of default on its borrowings, an event which would cause claims to be made against the guarantor (See the discussion in Part B Scenario (iii) above). In such cases where there are unlikely to be comparables regard would have to be had to subsection 136AD(4).

146. The price that an independent guarantor would seek for the guarantee would reflect the

nature and level of risk being assumed and the probability of the guarantee being invoked. It would not be expected that the independent guarantor would obtain any benefit other than the fees it obtains for the provision of the guarantee. Where other economic or financial benefits accrue to the guarantor as a result of the financial structure and strategy being employed, a question arises as to the economic substance of the arrangement between the parties and it would be inappropriate in such circumstances to determine what price if any should be charged for the guarantee without regard to those other benefits. Depending on the nature and extent of the additional benefits the CUP method may not be appropriate or may need to be used in conjunction with other transfer pricing methodologies.

147. In the open market the risk of default by a company in relation to its borrowings is

determined by reference to the standard tests for creditworthiness and the credit rating determined by that process. The tests include an analysis of its debt:equity ratio, the interest cover in terms of business profits that the business generates relative to the interest expenses it will have to meet (typically referred to as ‘times interest cover’), and the free cashflow on an annual basis relative to the interest payments and principal repayments for the year (typically referred to as the ‘debt servicing ratio’). Liquidity issues may also have a bearing; for example where short term liabilities are greater than current assets, or where cashflows within the borrower’s business depend on less favourable terms of trade than the business affords to trade creditors and overdrafts are needed. Invariably the analysis involves a consideration of what would happen in the event of a default.

148. For industrial companies the Altman model for predicting distress (generally referred to as

the Z Score Bankruptcy Model) seems a useful approach to ascertaining the probability of default. Since it is based on financial ratios it is more likely the required information will be available. The Altman approach is reflected in modern publicly available quantitative risk rating models.

149. There are problems in applying the standard tests in relation to determining

creditworthiness on a stand-alone basis when the parent company has established the capital structure of its subsidiary with a level of equity that would not enable the subsidiary to be financially viable. Without much capacity to absorb losses the providers of debt funding would be much more exposed and would not lend. In such circumstances a guarantor in effect assumes the risk to the extent that lenders generally would find it unacceptable. If the subsidiary is unable to borrow on a stand-alone basis a guarantor would be assuming the risk of default in relation to the debt funding and will be explicitly



or practically subordinated to guaranteed creditors and possibly all other creditors. Since in such a case the debt financing is funding most of the balance sheet the subsidiary is not viable without it. A subsidiary’s cost of funds may be critical in markets where there is strong price competition. Accordingly if the parent is intent on pursuing a thin capitalisation strategy it is going to have to provide the required debt funding or guarantee its provision by third parties. In either case the parent is assuming credit risk in relation to the debt, albeit in the second case it is secondary in nature since it arises in a practical sense only where the subsidiary defaults.

150. By ensuring financial viability of a subsidiary the guarantor underwrites the potential

financial upside that accrues to the parent as shareholder in respect of the equity invested - and enhances the return on that equity. An independent party would be unlikely to assume part of the investment risk by providing a guarantee to a party that was not creditworthy without a commensurate share of the potential upside that would normally accrue to an equity participant, or a very significant fee, assuming the investment was in other respects sufficiently attractive. This is not an issue where the guarantee is provided by the parent company because, in the case of a wholly owned subsidiary, it is already entitled to any financial upside by virtue of its existing shareholding.

151. A parent company would not establish an offshore subsidiary with a thinly capitalised

structure supported by a guarantee unless it provided a benefit to the parent relative to other financing options. However the bulk of the cost of such a strategy is borne by the subsidiary in the form of additional interest expense and correspondingly less profit relative to the risk imposed by the thinly capitalised structure. Notwithstanding this it is asserted in some quarters that the subsidiary should incur additional fees for the provision of the guarantee. However, in cases of this kind the guarantee is inextricably bound up with the establishment and maintenance of the participation by the parent in the business of the subsidiary. On a broad perspective the costs are shareholder costs and the subsidiary should not be charged for such a facility.

152. In a case where the subsidiary is creditworthy on a stand-alone basis but its parent company

has a stronger credit rating, the provision of a guarantee by the parent may allow the subsidiary to borrow on the same or very similar terms to the parent. In such a case independent parties may be prepared to enter a guarantee arrangement where each party sees a reasonable prospect of advancing its economic interests and the proposal was more attractive than other available options. Banks and other financial institutions often provide guarantees and sureties to clients for a fee. For example a company may pay a bank a fee to endorse a commercial paper issue so that the company can raise debt funding at a cost determined by the bank accepted bill status thereby obtained. A borrower company would only do this if the total cost of the bank support did not exceed the saving in interest or discount and the fee and costs being charged by the bank were competitive with the fees and costs being charged by others providing a similar service. However, in such cases regard would also have to be had to the fact that the higher credit rating may facilitate the raising of the debt funding needed by making the commercial paper more marketable and by improving liquidity in the instrument.



153. It is important to remember that the CUP method requires a comparison with an uncontrolled transaction or arrangement that has actually taken place. It is the use of the price in the open market between comparable independent enterprises in comparable circumstances that gives the price reliability as a benchmark. Accordingly, where for instance a borrower obtains a written quote from an independent third party such as a bank for the fee it would charge to give a guarantee, this is not a true CUP if the circumstances on which the quote was obtained do not reflect the actual facts and circumstances in relation to the party seeking the guarantee and the guarantee is not actually given and the quoted fee not actually charged. The reliability of such quotes will depend on the particular facts and circumstances and the context in which the quote is obtained.

Comments are invited on the use of the CUP method, and in particular as to possible sources of data for applying this method to demonstrate the various elements of comparability.

Use of a benefit approach (“spread method”)

154. A benefit approach or “spread method” seeks to value a guarantee from the perspective of the borrower. From the borrower’s perspective it has regard to the expected benefit it may derive through lower interest rates charged on its guaranteed borrowings compared to what would be charged on otherwise comparable borrowings without the guarantee. The borrower would also take into account that in the open market the borrowing company would have to pay the transactional costs as well as the fee negotiated with the provider of the guarantee. It would also be expected that independent companies considering entering such a guarantee arrangement to support their borrowings would have regard to any market indicators of the fees and charges applicable to comparable arrangements. From the perspective of an independent party contemplating whether to provide a guarantee it would be necessary to have regard to the nature and extent of the risk that would be assumed were a guarantee to be provided to the borrower and to the rate of return the market is offering for such risks. Independent parties would each have regard to their costs and benefits, taking account of market indicators relevant to their circumstances and would enter a guarantee arrangement only if it was the best economic option available.

155. For example, a parent company may be ‘AA’ rated and its subsidiary ‘BBB-’ on a stand-

alone basis. Since BBB- is ‘investment grade’ the subsidiary would be able to raise debt funding without support but subject to the limits presented by the size of its balance sheet, its profitability and cashflow. A parental guarantee may enable the subsidiary to raise the debt funding it needs based on an ‘AA’ rating, whereas without the guarantee the cost of the debt funding would be based on a ‘BBB-’ rating. In this situation, the guarantee fee is based upon the spread between the interest rate payable by the subsidiary as an ‘AA’ rated borrower and the rate it would pay as a ‘BBB-’ rated borrower and an arm’s length outcome depends on what independent parties in comparable circumstances would have done in terms of sharing the spread.

156. The spread method seeks to value the expected benefit to the borrower, and in so doing

estimates what it might be expected to be willing to pay for that benefit. However, if the



guarantee fee were to equate with the whole of the interest rate spread then, given transactional costs would also be incurred, there is unlikely to be incentive sufficient for the borrower to enter into the guarantee arrangement compared to the option of simply borrowing directly in the open market on an unsecured basis. Similarly if the borrower could obtain lower fees and charges in the market for the same benefit it would be expected that the borrower would not enter an alternative arrangement unless it produced a better or at least equal outcome to that otherwise available.

157. It might be argued in some cases that the borrower benefits from the guarantee by being

able to borrow where it could otherwise not have done so (because an independent lender is unlikely to lend at all without the guarantee). However, in this situation the interest rate reference points (and the use of this method) become purely hypothetical and unreliable unless adjustments can be made to improve comparability sufficiently to ensure the outcomes are reliable.

158. The quantification of the spread is only the first step to determine an arm’s length guarantee

fee. It is important in this regard that the spread is calculated on the basis of the rate of interest that the parent company actually gets in the market, not the implied interest rate derived from the parent’s credit rating, which can be misleading because the credit rating is based on a longer term stable set of conditions. In other words the notional rate based on a credit rating of say AAA may be lower than the rate at which the parent company is actually borrowing, which may for example be more aligned with a AA rating. The critical second step is to quantify what discounting of the spread would reflect the outcome of arm’s length bargaining between the guarantor and the borrower.

159. The spread method does not directly benchmark against an uncontrolled guarantee fee, but

rather uses uncontrolled loan interest rates, risk assessments and market indicators as indirect benchmarks for a guarantee fee. A loan and a guarantee are not directly comparable transactions, in particular as regards terms and conditions and the risks assumed by a lender and a guarantor. A loan interest rate is not directly comparable to a loan guarantee fee. The interest rate payable on a loan may be considered to comprise two components of compensation to the lender: first, compensation for the time-value of the money lent, and secondly adequate compensation for credit risk assumed. Realistically, the setting of an interest rate is relevant only if the borrower is creditworthy. Industry practice is to determine an interest rate in such cases by reference to the risk-free rate which is then increased by an appropriate margin. The margin is intended to reflect the risk associated with lending to a particular borrower in a particular industry having regard to the borrower’s circumstances and broader economic and country criteria. The margin takes account of the possibility of loss on account of a bad debt being incurred, whether through business failure or economic downturn, and depends on the lending demographic and the risk profile of the particular loan portfolio.

160. Loan guarantee fees effectively represent only compensation for the risk assumed by the

guarantor, which is the risk that the borrower may default and the lender may call upon the guarantor for payment. Hence the conditions which may cause the borrower to default, whether within the borrower’s business or externally generated, become a key focus of the analysis of the potential guarantor. The spread in rates between a guaranteed loan and an



otherwise comparable unguaranteed loan represents the range in which the borrower and the guarantor would negotiate the reward for the credit risk assumed by the guarantor, and the benefit the borrower would want, in order to make the guarantee arrangement sufficiently attractive. However, the guarantor may be unaware in some cases of the precise difference the guarantee would make to the interest rate charged to the borrower. This is unlikely to be a problem where the arrangement between the borrower, lender and guarantor are covered in the same documentation, a step that may assist enforceability by the creditor against the guarantor.

161. In circumstances where the spread is insufficient to provide the required benefits to both the

guarantor and the borrower, as a matter of commercial reality independent parties dealing wholly independently with each other are unlikely to enter the arrangement. Accordingly in such cases it is not possible to determine an arm’s length price for the provision of a guarantee without making adjustments to sufficiently improve comparability with what independent parties would do in comparable circumstances. This would require recourse to subsection 136AD(4).

162. A key factor impacting the relative reliability of the spread method is the nature of the

evidence used to support the quantification of the interest rate spread and to determine how independent parties would have shared the spread. Given that the lender of the guaranteed loan is an independent third party, the interest rate of that loan is inherently arm’s length, though it is influenced by the existence of the parent guarantee. Thus, the major issue in reliably quantifying the spread is the data used to establish the interest rate on a comparable loan without the guarantee. One possible source of such data might be other loans that the borrower has raised in the same market conditions and on the basis of the same business operations and balance sheet without any guarantee. Such loans must be comparable to the guaranteed loan in all respects other than the guarantee. This includes the terms and conditions of the loan and all other circumstances that might affect the interest rate, such as the borrower’s financial and other business circumstances and the economic and market environment when the loan was obtained. If no such internal comparables are available, it might be possible to use contemporaneous external data for interest rates payable by independent companies in the same industry with the same credit rating to what the borrower would have without the guarantee, assuming that the borrower is creditworthy and competitive on cost of funds with other participants in the industry. It is likely to be more difficult to establish comparability of all factors affecting the setting of the interest rate using such data, thus reducing the reliability of the method.

163. In some cases, data as to the interest rate that would be charged without the guarantee may

evidence a notional rate, in the sense that there is never an actual loan to the borrower at that rate. For instance, the lender making the guaranteed loan may be requested to also give a quote on a comparable unsecured borrowing, with this quote being used for purposes of determining the spread and hence quantifying a chargeable guarantee fee. In this situation there are likely to be issues as to the reliability of the evidence of the unsecured interest rate, particularly if the lender required the guarantee before it lent, and hence was not in fact prepared to lend on an unsecured basis.



Comments are invited on the use of a spread method, the circumstances in which it might be appropriate, the possible sources of data for applying this method and its reliability in determining an arm’s length fee. Comments are specifically invited on appropriate methodologies to determine the discount to arrive at the arm’s length fee for a guarantee.

Use of a risk/reward based approach (a cost based approach)

164. It is necessary to consider whether a risk/reward based approach may assist in determining the arm’s length price for a guarantee. The starting point is to determine that the guarantee transaction is one that would be contemplated by independent parties acting wholly independently and considering the circumstances of the borrower on the basis that it is separate from its parent. A risk/reward based approach seeks to value the guarantee from the perspective of the guarantor by focusing on its actual and potential economic and financial impacts of providing the guarantee. For instance, it may be possible to estimate the guarantor’s risk by reference to the amount guaranteed, the likelihood of default, the costs of providing adequate capital cover and any transaction costs not able to be passed on. The reward would be based on the quantified risk and perceptions of the probability that the risk will not materialise compared to the probability that it will materialise.

165. The borrower’s creditworthiness is an important factor in applying this method since it

bears directly on the financial strength of the borrower and its risk of default. The reliable application of the method requires that the guarantor’s expected cost is based upon an arm’s length creditworthiness for the borrower, determined as per Part D of this paper.

166. Where there is insufficient data to reliably benchmark or otherwise quantify an arm’s length

margin for the assumption of the quantified risk, the use of this method alone is unlikely to be the most appropriate way to determine an arm’s length guarantee fee. In such circumstances, consideration might be given to using a combination of methods.

Comments are invited on the appropriateness and potential to use a risk/reward based approach, the elements comprising the approach and the possible sources of data for applying this method and how to reliably determine an arm’s length premium or fee.

Other approaches

167. In some circumstances a method other than one of those discussed above, or a combination of more than one of those methods, may be considered the most reliable basis for estimating an arm’s length guarantee fee.

Profit split method

168. There may be cases where the guarantee arrangement is one of a number of related party

dealings that bear on the profitability of a subsidiary and its parent. Other cases may




involve complicated financial structures that require a number of elements to be considered together in order to determine their true purpose and effects. In such cases the use of a profit split method may be the most appropriate method.

Option pricing model approach

169. This method, which involves quite complex economics, seeks to determine an arm’s length guarantee fee using an accepted financial model for valuing options (eg. Black-Scholes). The theoretical basis for this method is the treating of the guarantee fee as equivalent to a premium chargeable for insuring the underlying loan asset. In effect the parent in providing the guarantee has given the independent lender a put option. The value of the put option is the cost of the guarantee.30 It has been suggested that on this basis the fee can be calculated using approaches similar to pricing a put option by which the borrower has the right to sell the loan asset to the guarantor at a specified price (presumably reflecting its face value and interest entitlements) if the loan value falls below that price (as is likely to be the case in the event of a default).

170. The Merton Model gives a probability of default. Inputs to the model are the market value

of assets, the volatility of the market value of assets and the default point (generally based on the short term debt plus some percentage of long term debt). It is not clear whether the use of the option model is limited to listed entities.

171. Credit default swaps have been suggested as a benchmark for the pricing of guarantee

arrangements. The credit default swap allows one party to make periodic fixed payments to the counterparty in return for receiving credit protection should nominated events of default occur. It has been said that in all material respects a credit default swap is equivalent to a financial guarantee.

30 Ross, S A, Westerfield R W, Jordan B D 2006, Fundamentals of Corporate Finance ‘7th edn’, McGraw-Hill Irwin, New York, p. 458.

Comments are invited on the use of a profit split method, the circumstances in which it may be appropriate, the basis on which appropriateness could be justified and the possible sources of data for applying this method to complex arrangements involving the provision of guarantees.



Use of a range of results

172. The above discussion of methods for pricing guarantees suggests that, depending upon the circumstances, a single pricing method may produce more than one possible arm’s length outcome, or that more than one method may be equally reliable as a basis for estimating an arm’s length outcome. In such cases there may be a range of possible arm’s length guarantee fee rates or amounts.

173. The use of a range of results in setting or reviewing a guarantee fee should follow the

general guidance at paragraphs 2.83 - 2.95 of Taxation Ruling TR 97/20. If a true arm’s length range of fees is properly constructed using comparables data with a high level of reliability, with all points in the range being equally reliable as estimates of an arm’s length outcome, then any fee within the range is considered arm’s length. In other cases, results of lesser or varying reliability as estimates of an arm’s length outcome may be used to construct an approximation of an arm’s length range. For instance, the use of more than one method may tend to produce a broad range of fees such that not all points in the range may be regarded as arm’s length. The use of such a range requires a judgment to be made as to which point in the range best accounts for the facts and circumstances of the related party dealings. To be a reliable estimate of an arm’s length outcome, the chosen point in the range must make commercial sense in the taxpayer’s circumstances. In the absence of arm’s length comparables regard would have to be had to subsection 136AD(4).

Requirement for outcomes to make commercial sense

174. Comparables data used as an arm’s length benchmark for the pricing of a borrower’s intra-

group loans and guarantees is reliable for determining an arm’s length outcome only if that

Comments are invited on the appropriateness of the combined use of the spread method (benefit approach) and risk/reward based approaches (cost approach) to estimate an arm’s length price for a finance guarantee.

Comments are invited on the use of an option pricing model approach, and in particular as to why this may be an appropriate method, the circumstances in which it can be used as the most appropriate method and the possible sources of data for applying such a method. Comments are also invited as to the scope for using credit default swaps, Z scores, option models and/or Basel II concepts as a sound basis for pricing guarantees in accordance with the arm’s length principle. In this regard views are sought as to whether such approaches are capable of practical application in a wide range of cases or are confined to particular classes of case.

Comments are invited on how ranges of results are most appropriately used in determining an arm’s length price for a finance guarantee.



outcome makes business and commercial sense in all of the borrower’s circumstances31. As an independent party, a taxpayer has the option of transacting at a market price if this makes commercial sense in the taxpayer’s circumstances.

TR 97/20 states32:

“3.2 The successful application of the arm’s length methodologies (and in particular

the traditional methods) establishes the consideration and contractual terms that prevail in the open market. It does not necessarily follow that it is always appropriate to adopt that consideration in the dealings between related enterprises. When dealing at arm’s length, the parties generally have the option not to proceed with the dealings if the market prices do not satisfy their profit expectations or business strategies.

3.3 For example, if the prevailing market prices lead to unsatisfactory profit levels,

then dealings may ultimately not be concluded or may be conducted in a different manner or on different terms. This indicates that arm’s length dealings involve both the establishment of the market terms and conditions and an assessment of the implication of these dealings for the profits of the enterprise.”

175. An independent party would not ordinarily be expected to agree to incur financing expenses

at a level that would prevent it deriving a commercially realistic rate of return for the functions performed, assets used and risks assumed in its business. It would be expected in arm’s length dealings that the parties have sufficient freedom to accept or reject a particular proposal. Where this is not the case and the circumstances are such that independent parties dealing wholly independently would not contemplate the arrangement, questions arise as to the nature and effect of the transactions under scrutiny and the purposes and objects of the participants. This issue may arise where a borrower has a low arm’s length creditworthiness, and hence incurs relatively high rates of related party interest and/or guarantee fees which result in its bottom line profitability being significantly below that of comparable uncontrolled enterprises. In this situation the Tax Office would need to understand how such arrangements and outcomes make commercial sense in the borrower’s particular circumstances. This in turn may raise questions as to the purpose and effect of the guarantee arrangement. Absent a reasonable explanation, the application of a transactional net margin method (‘TNMM’) using data as to operating profits (net of financing expenses) for comparable uncontrolled enterprises may be appropriate to determine an arm’s length outcome for the borrower. Given that Division 13 is drafted in terms of the ‘consideration’ properly payable under an ‘international agreement’ between independent parties dealing at arm’s length with each other, in making a determination the amount derived from the use of a TNMM would then need to be recalculated as a varied interest rate on the relevant debt funding as appropriate.

31 TR 97/20 paragraphs 2.15-2.17. 32 TR 97/20 paragraphs 2.17, 3.27 and 3.51.

Comments are invited on the types of circumstances in which it might make commercial sense to incur financing expenses at a level that produces losses or profitability below what would ordinarily be expected as a reward for the functions, assets and risks of a business.


Cases where it is not possible or practicable to determine an arm’s length consideration for a guarantee

176. Where a guarantee is given in circumstances where an independent party dealing wholly

independently would not have provided a guarantee and the borrower would not have been able to obtain a guarantee from an independent party (eg where a borrower is not creditworthy on a stand-alone basis and the risk is unacceptably high) it may be that it is not possible or practicable to determine an arm’s length fee for such a guarantee. In such circumstances it may be that there are no independent comparables or that the comparability required by the arm’s length test cannot work because of the non-arm’s-length nature of the whole situation. In such cases it will be necessary to consider the application of subsection 136AD(4) of Division 13.

177. Australia’s double taxation agreements protect the operation of Division 13 in such

circumstances but require it to be applied consistently with the principles embodied in the Associated Enterprises Articles of those agreements. Accordingly, apart from the other requirements arising from the terms of the relevant treaty and Division 13 a question arises as to whether the giving of a guarantee as part of the financing framework for a subsidiary that would otherwise not be creditworthy results in a misallocation of profit relative to what would have been the case if the parties had been independent of each other and were acting wholly independently. A similar question is posed by Division 13 (though it is framed in terms of transactions that result in less assessable or exempt income or higher allowable deductions than would have been the case if the parties had been dealing at arm’s length). The application of subsection 136AD(4) needs to be guided by the purposes of the Associated Enterprises Articles and Division 13.

178. As discussed in the earlier parts of this paper, the nature and effects of the full set of

relevant arrangements between the parties need to be understood, as well as the purpose and objects of those arrangements.

179. As discussed above an independent lender would not advance debt funding to an

independent borrower that was not creditworthy. In such a case there is no arm’s length interest rate. In applying subsection 136AD(4) regard would have to be had to the adjustments that would need to be made to make the borrower creditworthy. The methodology for determining the arm’s length interest rate would have to accommodate such adjustments in the way described in Scenario (i).

180. Independent parties considering the provision and obtaining of a guarantee would have

regard to the economic circumstances of the borrowing company seeking the guarantee. Where the borrowing company cannot borrow on the basis of its own economic circumstances an independent party would not provide a guarantee because the credit risk (and hence the probability of default) is too great. Accordingly there is no arm’s length fee for a guarantee in such circumstances. In the application of section 136AD (4) adjustments would need to be made to conform the tested situation to one where an independent party would be prepared to give a guarantee. (See the earlier discussion in relation to Scenario (iii) )



181. Where on a proper consideration of all the facts and circumstances the provision of a guarantee relates exclusively to the establishment or maintenance of a parent company’s participation as an investor, the costs of such participation should not be allocated to the subsidiary and should not affect the allocation of profit between the parent and subsidiary. In such a case the viability of the subsidiary depends on the guarantee. The charging of a fee in such circumstances has the effect that the borrower subsidiary suffers an expense and the parent obtains a commensurate amount of income in circumstances where the parent is already carrying the economic risk of the viability of its investment in its subsidiary. The parent’s entitlement to profit is determined by its participation. There is a reduction in Australian tax payable in circumstances that would not support a charge being made. Accordingly it would be fair and reasonable in those circumstances to determine that the arm’s length consideration for the provision of the guarantee is nil. Scenario (iii) covers this situation.

182. The analysis of notching and informal support like the provision of letters of comfort are

relevant matters to be considered in the context of subsection 136AD(4).

Comments are sought on how the concept of comparability can be applied where the level of debt funding used by the borrower company exceeds the arm’s length amount (even though it may be within the statutory safe harbour for thin capitalisation purposes). Comments are sought on the circumstances in which subsection 136AD(4) may have an operation and the factors that should be taken into account in its application.

183. Industry practice is to assess the credit rating of a party seeking a loan or a guarantee. In setting the rating regard is had to the economic circumstances of the party seeking the loan or the guarantee and to market and economic factors that may affect the level of credit risk. The outcome of the process is described in terms of the creditworthiness of the party seeking the loan or the guarantee.

Part D: Determining creditworthiness for purposes of applying the arm’s length principle to intra-group finance guarantees and loans

184. A borrower’s creditworthiness and the risk profile of the party giving a guarantee are key determinants in relation to the amount if any that should be charged for a finance guarantee because they are critical to the identification of the expected benefits from the guarantee arrangement for the respective parties and whether and how the risks of each of the parties have changed as a consequence of the giving of the guarantee. Similarly, a borrower’s creditworthiness is a key factor in determining whether an independent party would be prepared to lend to it and in determining the interest rate and other conditions (such as security, negative pledges and financial reporting obligations) that may attach to the loan (assuming that the borrower is creditworthy).

185. Accordingly, where a borrower and a guarantor or lender are related parties, the application

of the arm’s length principle in determining a guarantee fee rate or loan interest rate requires that regard be had to the creditworthiness of the borrower considered



independently of its parent. Unless an MNE group member is hypothesised as if it were an independent stand-alone entity separate from the group and its other members it is impossible to determine whether conditions operate between the parent and subsidiary that distort what would have occurred if the parties were independent of each other and dealing wholly independently with each other. The essence of the arm’s length principle is the reliability of the outcomes produced by independent parties dealing wholly independently with each other in the open market. It is the absence of any organisational influence or impact and the economic tension between the parties in these circumstances in seeking to optimise their economic outcomes that generate the reliability.

186. Paragraph 1.6 of the OECD Guidelines states:

“By seeking to adjust profits by reference to the conditions which would have obtained

between independent enterprises in comparable transactions and comparable circumstances, the arm’s length principle follows the approach of treating the members of an MNE group as operating as separate entities rather than as inseparable parts of a single unified business. Because the separate entity approach treats the members of an MNE group as if they were independent entities, attention is focused on the nature of the dealings between those members.”

187. If it is a factual condition of an MNE group member that in the particular circumstances it

is viewed in the marketplace as having the same creditworthiness as the group as a whole or as its parent company, it is necessary to enquire whether the marketplace has formed that judgment as a result of conditions that operate between the parent and the subsidiary that make them financially interdependent, or whether the parent and subsidiary are being separately evaluated as being equally creditworthy. There may be cases where a subsidiary obtains incidental benefits attributable solely to its being part of a larger concern, and not to any specific activity being performed by the parent for the benefit of the subsidiary, as set out in paragraph 7.13 of the OECD Guidelines. In such a case of incidental benefit, for example where the market notches up the credit rating of a subsidiary because of its affiliation, there is no service provided by the parent that would warrant a fee be charged to the subsidiary. Where the market has formed the view that the parent and subsidiary are financially interdependent, it is necessary to understand the conditions that operate and their impacts on the businesses of the subsidiary and the parent since these conditions may be the source of a transfer pricing problem.

188. Accordingly, an arm’s length creditworthiness can be defined for purposes of applying the

transfer pricing rules as being the level of creditworthiness at which an independent party would regard the risk as acceptable in providing a loan or guarantee to a borrower company without requiring financial support undertakings from its parent, and which results in a cost to the borrower that allows it to remain viable and obtain an acceptable return for its line of business. Thus, an arm’s length creditworthiness for a borrower is appropriately determined using the criteria an independent lender or guarantor would use to determine the probability of default if its only redress were against the borrowing subsidiary.



Comments are invited on the role of creditworthiness for purposes of applying the arm’s length principle to intra-group finance guarantees and on how to determine creditworthiness where a borrowing subsidiary has a level of debt that exceeds the arm’s length amount.


intra-group finance guarantees and - transfer pricingtransferpricing.com/pdf/australia_thin...

Documents