An idea worth considering | April 1, 2010

It is often said that "if it's too good to be true, it is." This truism should form the cornerstone of any solid income tax planning model. After all, if something is too good to be true (e.g., hybrid results, double deductions, double economic non-taxation, form over substance, income assignments, etc.), then it probably is — correct? This concept is particularly relevant for MNEs (multinational enterprises), since they must deal in multiple tax jurisdictions that often have differing rules, regulations, policies, practices and procedures, and differing views on what, if anything, is too good to be true.

Suppose, however, that a transaction opportunity arises where an MNE utilizes a basic form in which one MNE pays a service fee to another, resulting in a simple, straightforward tax result (deduction for payor, income inclusion for recipient). Suppose further that the MNE can show that although the transaction occurs across international borders within a single MNE, it achieves arm's-length results because an uncontrolled party would pay a similar fee to another uncontrolled party. Here, no one could seriously argue that the results are too good to be true; instead, the truism isn't likely to apply or arise.

Recently, however, a bit of a tax brouhaha — or depending upon one's perspective, a full-blown, bare-knuckle, Pier-7 brawl — has arisen over intercompany guarantees. Arguably, this is somewhat curious since basic transaction is rather innocuous: The MNE parent guarantees payment or performance by an MNE subsidiary in a commercial transaction. In return, the subsidiary pays the parent company a fee for the guarantee. The typical tax result is a deduction by the subsidiary and an income inclusion by the parent.

Clean, straightforward and sustainable. Correct?

Well, let's pause for a moment and consider the "too good to be true" paradigm. And to see whether the transaction would survive a tax authority's scrutiny, let's put on a tax-authority hat — and let's make it the well-worn hat of a veteran but highly skeptical tax inspector, who is generally lacking in tolerance for outbound fee payments (with corresponding deductions) that in the inspector's view, are "self-created" and unduly strip taxable earnings from the local tax base. Viewed in that light, could it really be the case that a parent and its controlled sub can, through the stroke of the pen in an intercompany agreement, create deductions and shift income via intercompany fee payments? Indeed, in the inspector's view:

  1. The transaction only exists because it can: In other words, the MNE controls both sides of the transaction, and can easily "paper" the transaction via a contractual provision that specifies the deduction.
  2. The transaction is illusory: No MNE parent would allow its subsidiary to fail or to not perform. Stated differently, if a subsidiary were to fail its obligations, the parent would be hard-pressed not to step in and perform, thus providing implicit support to the subsidiary.
  3. That implicit support could take many forms, one being a nontaxable (and nondeductible) contribution of capital. That is, if the subsidiary is failing, the parent would, could and should contribute additional capital to assist its failing or flailing sub.
  4. It would follow in the inspector's view, therefore, that an intercompany fee payment does not generate an ordinary, necessary or reasonable tax deduction. Instead, the arrangement is simply too good to be true, because the controlled intercompany contract creates an artificial, superfluous deduction.

Further to the inspector's hypothesis, let's ignore the deduction results in taxable income in the payee's jurisdiction — which is not the concern of the inspector examining the subsidiary's return. Further, let us brush aside that economically, the transaction could be a wash: Without the guarantee, perhaps the sub would pay a higher market interest rate on a non-guaranteed loan, whereby the sub's higher interest deduction would equal the sum of the lower guarantee-backed interest amount plus the guarantee fee. Finally, let's stifle the urge to complain that the inspector's lack of real-world business experience hasn't stopped the inspector from second guessing the business judgment of an MNE that engages in numerous real-world commercial transactions. Fair points all, but at the exam level, the inspector will be right not because he or she is correct, but because he or she is the inspector. So what, if anything, could be said to the inspector to sustain the deduction?

Guarantee fees

Overview

Of course, we know that in general, controlled transactions between or among MNE entities must achieve arm's-length results under applicable transfer pricing provisions. Unquestionably, intercompany guarantees fall under those provisions. Further, since the U.S. transfer pricing regulations typically lead the league in content, coverage and complexity, surely the U.S. regulations will specify how to price an intercompany guarantee. Correct?

The answer is no. The U.S. regulations are curiously silent regarding specific guidance for intercompany guarantees. One finds only a cursory reference to guarantees buried deeply within the U.S. service regulations. But that reference establishes merely that "financial transactions, including guarantees" are "excluded activities" for purposes of pricing certain low margin services at cost. In other words, financial guarantees are not eligible for the "services cost method" under the U.S. regulations. Other than that reference, the U.S. regulations are silent.

Several IRS officials have stated publicly that they anticipate releasing guidance on guarantees. But to date, no such guidance exists. Why?

Foremost, there are numerous types of marketplace guarantees. To name just a few: bid bonds, performance guarantees, advance payment bonds, retention bonds, payment guarantees, counter indemnities and many, many more, depending upon industry and market specifics and conditions. In fairness to those who would attempt to write transfer pricing regulations, it would be difficult to develop comprehensive, meaningful guidance for pricing transactions that can occur in so many different forms. Yet on the other hand, comprehensive guidance exists for the broad categories of "tangible" (e.g., widgets and digits) and "intangible" (license or transfer) transactions. Those transactions can be complex, so why no guidance for guarantees? Whatever the reason, no guidance exists presently.

So, how can we price guarantees? In general, any basic internet search for "international guarantees" reveals numerous transactions in which banks and other financial institutions offer a wide range of guarantees. In other words, the transactions clearly occur in the real world. As such, one could venture a strong, educated guess that (1) those institutions are not offering their services for free, and (2) comparable fees would, could and should be charged between or among controlled entities in accordance with basic transfer-pricing principles. Accordingly, it's a bit of a no-brainer that the MNE subsidiary in our example above, would, could and should pay an arm's-length fee for a parental guarantee. And so, it would seem that any reasonable tax inspector who examines a guarantee fee should only be concerned with the amount — specifically, whether arm's-length consideration is paid and received — and not whether the transaction would, could or should be recast or ignored.

The GE Capital Case in Canada

Recently, the Canadian courts addressed guarantee fees in the context of a case involving GE Capital (GEC). Between 1988 and 1995, GEC-US provided, at no cost, an explicit guarantee to GEC-Canada for GEC-Canada's debt issuances. Starting with its 1996 tax year, GEC-US started charging a guarantee fee of one percent of the face amount of GEC-Canada's issuances. This resulted in $135.4 million in deductions over a five-year period (1996–2000) for the fees that GEC-Canada paid to GEC-US. The Canadian government denied the deductions. GE Capital took the case to the Canadian courts — and won.

The Canadian inspector had denied the deduction by asserting (among other things) that the fee was superfluous. Further, the Canadian government asserted numerous valuation theories to address the "how much" question; i.e., assuming that a fee generates an allowable deduction, what is the right price? But the government's basic premise centered on the notion that no deduction whatsoever was allowable because (1) GEC-US would have supported GEC-Canada regardless of the guarantee, and (2) the guarantee conferred no benefit on GEC-Canada, because it had the implicit support of GEC-US, such that its credit rating would be the same whether the guarantee was in place or not. Therefore, in the government's view, the guarantee arrangement was superfluous.

As noted, GEC took the Canadian government to court and won. The court decisions (trial court and appellate) discuss the various techniques that numerous expert witnesses used to determine "how much." Those techniques included credit swap methods, insurance models, the yield method and others. In fact, since both the government and GEC agreed that there were no true comparables for the specific transactions at issue, the parties utilized their expert witnesses to answer "how much," thereby engaging in the classic battle of the experts that all-too-often is a characteristic of U.S.-style transfer pricing litigation. And so, the Canadian courts examined the various pricing approaches of the parties' respective experts and determined that the deductions that GEC-Canada took did not exceed arm's-length amounts that certain experts determined. Accordingly, the courts upheld the full amounts of the GEC-Canada deductions.

The intriguing aspect of the case, however, is not so much the "how much" — i.e., which valuation method provides the most-reliable evidence of the arm's-length prices for the fees. Instead, it's whether GEC-US's implicit support of GEC-Canada is relevant to determining how much GEC-Canada should pay in guarantee fees. Here, one particular valuation method — the yield method, which the trial court applied — considers that "implicit" factor. And therein resides the conundrum: Should an arm's-length analysis, which generally hypothesizes stand-alone, independent entities — factor implicit support into the equation, given that the implicit support arose because of the controlled relationship?

The trial judge noted that although the Canadian transfer pricing statute invites him to ignore the "non-arm's-length relationship" that exists within GE's MNE structure, the yield approach called for notionally removing the explicit guarantee in order to determine the credit rating that GEC-Canada would have obtained without the explicit guarantee (albeit as a member of the GE corporate family). Further, the appellate court clarified that the yield approach should measure the benefit that the explicit guarantee brought to GEC-Canada, compared to the benefit of implicit support. At least for arm's-length purists, however, an arm's-length price should not consider factors that are created by virtue of the intercompany relationship itself, e.g., implicit support or otherwise. Thus, there is at least a lingering "how much" issue of whether a factor generated by the intercompany relationship itself can or should affect the proper determination of an arm's-length range of prices.

The point

So, where does this leave us? One view — and often the launching pad for spirited, robust discussions within the international transfer pricing community — is that intercompany loans and guarantees are now fraught with uncertainty in the post-GEC world. But what if we were to consider, instead, this simple point: The taxpayer won. As such, the post-GEC world arguably is apocalyptic not for taxpayers, but for governments that attempt to ignore or recast transactions that exist in the real world and for which prices can be determined reliably through real-world benchmarks or economic valuation techniques.

Indeed, GE Capital was not just any case, and did not involve just any taxpayer. It involved one of the world's largest companies with over $135 million (plus recurring amounts, presumably) at stake. Further, the matter did not result in some one-off decision by an obscure court involving a small, one-off transaction or amount. Instead, here we have the biggest kid on the block (pardon the expression) fighting against the tax authority of a key OECD member and multijurisdictional treaty partner and winning in both the trial and the appellate courts. In short, even for transactions that do not involve Canada, MNEs are well-advised (subject to local-country adviser opinions, of course) to examine GE Capital for express guidance concerning (1) whether intercompany guarantee fees would, could and should be paid, (2) the key issue of price, including the proper determination of an arm's-length range and (3) the corresponding local-country tax deductions that are allowable.

As with other transfer pricing questions, guarantee-pricing questions typically may be answered by determining how much an arm's-length party would be willing to pay for an explicit guarantee. As noted, some fine tuning remains regarding what role, if any, implicit support should play in determining the price range (e.g., no role from a theoretical, transfer pricing purist standpoint, but perhaps some role under certain economic models or theories). That issue, however, should not mask the basic premise that a party to a controlled transaction would, could and should charge an arm's-length fee for a guarantee that confers a benefit to the recipient.

In closing, back to the context of the original question: Is it too good to be true that an MNE can draw up an intercompany contract in which one entity guarantees performance or payment of another and thereby generates deductions and income? Of course, one always can posit transactions that have no business purpose and are truly superfluous; e.g., purely tax-engineered transactions. However, third parties often will demand a parental guarantee when dealing with a subsidiary. Particularly in that circumstance (and with apologies for double negatives): Not only is a guarantee arrangement not too good to be true, but the transaction (1) can produce arm's-length results, (2) should be addressed in any robust transfer pricing planning or documentation study and (3) affords a tremendous opportunity for multijurisdictional tax planning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.