Bank guarantee_ Finance, Transfer pricing

RE: Intercompany back charge invoice (on a quarterly basis) for bank guarantee on behalf of other affiliates from the entity in EU (Service Provider) to APAC entity (Service Recipient) 

*SBLC stands for Standby Letter of Credit. It's a bank-issued guarantee that promises payment to a beneficiary (typically a seller or service provider) if the applicant (usually a buyer or customer) fails to fulfill their contractual obligations. Essentially, it acts as a backup payment method or financial assurance in various transactions, particularly in international trade. 

Service provider has paid a guarantee fee to a third party bank and now proposes to recover the same at cost from the benefiting entities.  

* Bank guarantee Back charge: 

1. All Bank guarantees recorded to the prepaid account by AP under document type COS. 

2. Once in a quarter send reminder to provide details for the bank guarantees to issue  either back charge invoices or reclass if the total is less than 500 USD.

3. Once file received from Kateřina filter 1) by currency, 2) by entity. Issue back charge invoices as per example from email using prepaid account which will be offset with AP entry

·        4. For the amount below threshold 500 USD-reclass from 'prepaid account' to xxx

·       5.  Exception for CZ entity- reclass to different account

* Need to be considered: 

1. Withholding tax on payment to EU

2. Threshold amount for the intercompany back-charge (e.g., USD 500)

3. Intercompany account and Intercompany agreement setup to charge 

4. Mark-up rate - charged at cost to the benefiting entities.  Note that there would be a separate service charge with a mark-up for the employee costs themselves that were assisting with the administration.

- What are the covenants levied by the bank on Service provider to provide this guarantee

- Restrictions (e.g., cash reserve ratios to be maintained): could be some opportunity cost involved which should be recovered ideally

-Have the benefiting entities getting any benefit in the form of lower interest rate because of the IC guarantee? If yes, a portion of that benefit can be considered as a service provided by Service provider to the related entities

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Complexities of intercompany financial transactions and transfer pricing.

Regarding the Mark-up at Cost for Bank Guarantee Fee:

Q: Service provider has paid a guarantee fee to a third party bank and now proposes to recover the same at cost from the benefiting entities. Mark-up on the intercompany invoice - charged at cost to the benefiting entities. Is this correct?

A: * General Transfer Pricing Principle (Arm's Length Principle): The fundamental principle in transfer pricing is the "arm's length principle." This means that transactions between related entities should be priced as if they were conducted between independent, unrelated parties under comparable circumstances.

 * Recharging at Cost for a Pass-Through Expense: If the EU entity (Service Provider) is solely acting as a conduit for the bank guarantee fee – meaning they are just paying it on behalf of the APAC entity and incurring no additional risk or performing no significant function beyond facilitating the payment – then recharging at exact cost (no mark-up) is generally acceptable. This is considered a "pass-through" cost.

 * The Nuance of "Service" for Administration- "Note that there would be a separate service charge with a mark-up for the employee costs themselves that were assisting with the administration" is crucial. This indicates that the EU entity is providing a service (administration) related to the guarantee. This administrative service should carry an arm's length mark-up.

 * The Bank Guarantee Fee Itself: The bank guarantee fee itself is essentially a financial cost. If the EU entity is simply paying this on behalf of the APAC entity, and is not taking on any additional financial risk (beyond simply being the counterparty to the bank for payment), then a pass-through at cost for that specific fee is appropriate.

 * Potential Complications - "Implicit Support" and "Shareholder Activity": The OECD Transfer Pricing Guidelines (Chapter X on Financial Transactions) emphasize the "accurate delineation" of financial transactions.

   * Implicit Support: If the APAC entity could not have obtained a bank guarantee from a third-party bank on its own, or could only have done so at a much higher cost, precisely because it is part of a larger, financially stronger group (and the EU entity is providing this "implicit support" by being the guarantor), then the mere pass-through of the bank fee might not fully reflect the economic reality. In such cases, the EU entity might be seen as providing a financial service beyond simple administration.

   * Shareholder Activity: If the bank guarantee is primarily for the benefit of the group as a whole, or to protect the shareholder's investment in the APAC entity, then it could be argued that the guarantee fee is a "shareholder cost" and should not be charged to the APAC entity at all. However, this is usually a high bar to meet.

What are the covenants levied by the bank on Service provider to provide this guarantee?

Understanding these covenants is vital for assessing the true nature of the service provided and the risks borne by the EU entity. Common covenants include:

 * Financial Covenants:

   * Debt-to-Equity Ratio: The bank might require the Service Provider to maintain a certain debt-to-equity ratio, ensuring it doesn't become overleveraged.

   * Interest Coverage Ratio: A minimum ratio of earnings before interest and taxes (EBIT) to interest expense, indicating the ability to service debt.

   * Leverage Ratio: Total debt relative to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

   * Liquidity Ratios: Current ratio (current assets to current liabilities) or quick ratio (acid-test ratio) to ensure sufficient short-term liquidity.

   * Minimum Net Worth/Equity: A requirement to maintain a certain level of equity.

 * Operational Covenants:

   * Restriction on Dividends/Distributions: Limits on payments to shareholders, especially if financial health is a concern.

   * Restrictions on Asset Sales/Acquisitions: Requirements to seek bank approval for significant asset disposals or new investments.

   * Restrictions on Further Indebtedness: Limits on taking on additional debt without bank consent.

   * Reporting Requirements: Regular provision of financial statements, forecasts, and other relevant information to the bank.

   * Change of Control Clause: The guarantee might be callable or require renegotiation if there's a change in ownership of the Service Provider or the group.

   * Compliance with Laws/Regulations: Standard clause requiring adherence to all applicable laws.

 * Cross-Default Clauses: A default on other debt obligations of the Service Provider or the group could trigger a default on the guarantee.

 * Information Covenants: Obligation to provide regular financial statements and other information to the bank.

Restrictions (e.g., cash reserve ratios to be maintained): could be some opportunity cost involved which should be recovered ideally.

Those should be considered!

If the bank levies restrictions that impose an opportunity cost on the Service Provider, this cost should ideally be factored into the intercompany charge to reflect an arm's length price.

 * Cash Reserve Ratios: If the Service Provider is required to keep a certain amount of cash on hand or in a restricted account as collateral for the guarantee, this represents a funding cost or opportunity cost (i.e., the Service Provider cannot use that cash for other investments or operations that would generate a return). This cost should be quantified and, from a transfer pricing perspective, could be part of the service fee charged to the APAC entity.

 * Increased Borrowing Costs: If the existence of the guarantee (and the associated covenants) negatively impacts the Service Provider's own credit rating or limits its ability to obtain other financing, leading to higher interest rates on its own borrowings, this is also an opportunity cost that could be considered.

 * Risk Premium: The Service Provider is taking on a contingent liability. While the direct fee from the third-party bank is being passed through, the risk of having to pay out on the guarantee (even if low) is borne by the Service Provider. An arm's length transaction might include a small risk premium for taking on this contingent liability. This is often harder to quantify but is a legitimate consideration.

Have the benefiting entities getting any benefit in the form of lower interest rate because of the IC guarantee? If yes, a portion of that benefit can be considered as a service provided by Service provider to the related entities.

Yes, this is a very strong and relevant point from a transfer pricing perspective, and it aligns with OECD guidance on financial guarantees.

 * Benefit Test: The core of transfer pricing for services is the "benefit test." If an intercompany service provides a benefit to the recipient that an independent enterprise would be willing to pay for, then a charge is appropriate.

 * Quantifying the Benefit: If the APAC entity is able to secure a loan from a third-party bank at a lower interest rate because of the EU entity's guarantee, that difference in interest rates represents a direct, quantifiable benefit to the APAC entity.

   * Calculation: You would compare:

     * The interest rate the APAC entity would have paid without the guarantee (its standalone credit rating).

     * The interest rate the APAC entity is paying with the guarantee.

       The difference is the "benefit."

 * Pricing the Guarantee Service: A portion of this benefit (or potentially a cost-plus approach based on the EU entity's costs and risks) should be charged by the EU entity to the APAC entity. The OECD Transfer Pricing Guidelines suggest various methods for pricing financial guarantees, including:

   * Comparable Uncontrolled Price (CUP): Finding similar guarantee fees charged by independent banks for comparable guarantees. This is often difficult due to unique circumstances.

   * Yield Approach: Quantifying the benefit to the borrower (the interest rate reduction) and determining an arm's length share of that benefit for the guarantor.

   * Cost Approach / Valuation of Expected Loss Approach: Calculating the expected loss to the guarantor from providing the guarantee and adding an arm's length mark-up.

   * Capital Support Method: Comparing the guaranteed entity's borrowing capacity with and without the guarantee and attributing a fee for the additional capacity.

Conclusion:

While passing through the direct bank guarantee fee at cost might seem straightforward for a pure pass-through, the reality of intercompany guarantees, especially with administration costs and potential financial restrictions/benefits, is more complex under transfer pricing rules.

You should aim to:

 * Segregate Costs: Clearly distinguish between the direct bank guarantee fee (which might be passed through at cost, assuming no additional risk by the guarantor) and the administrative service costs.

 * Mark-up Administrative Services: Apply an arm's length mark-up to the administrative service costs (employee time, etc.).

 * Analyze Financial Benefit/Risk: Critically assess if the EU entity is taking on any financial risk or if the APAC entity is receiving a financial benefit (e.g., lower interest rates, increased borrowing capacity) due to the guarantee. If so, a separate financial service fee (with an appropriate mark-up) may be required to compensate the EU entity for this benefit/risk, beyond just the pass-through of the third-party fee.

 * Document Thoroughly: All charges and their basis should be thoroughly documented in intercompany agreements and transfer pricing documentation to ensure compliance with local tax regulations and the OECD Guidelines. This helps to justify the pricing to tax authorities.

Consulting with transfer pricing specialists is highly recommended for such complex intercompany financial transactions to ensure full compliance and avoid potential tax disputes.

https://www.royaltyrange.com/news/importance-of-functional-analysis/

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1. financial guarantee : 

Letter of credit issue in buying transaction

In which case bank guarantee is required?