Tread cautiously on the guarantee path

By Fatema Hunaid, Partner, Transfer Pricing Services, Grant Thornton India LLP.

Companies must employ common sense while placing guarantee transactions.

One of the fastest growing economies of the world, India has given birth to several new breeds of multinational companies that have ventured into greener pastures overseas. Setting up an overseas arm means raising funds for its working capital and other requirements.

To meet this end, companies often rely on guarantees, letters of comfort, and so on. Such arrangements help the subsidiary obtain higher loan amounts and can also reduce the cost of borrowing.

Corporate guarantee is one such arrangement under which a company with stronger creditworthiness acknowledges financial support to a lending institution in respect of the loan borrowed by an affiliate with comparatively weaker creditworthiness.

The guarantee may also be of a non-financial nature such as performance provided by a parent company to third parties in respect of performance of its affiliates.

The under-pricing or non-receipt of guarantee fee by an Indian entity would result in revenue loss.

In guarantee transactions, the lender is assured of payment by the guarantor in case of a default or non-performance. No company would be willing to provide guarantee without any consideration except for the interest as a shareholder. Therefore, such guarantees come with certain costs.

Little guidance has been provided for benchmarking of corporate guarantee transactions, creating ambiguity in respect of arm’s length evaluation of guarantee fees. In the absence of proper external comparables, bank guarantees are often relied upon.

However, the National Company Law Tribunal in the recent case of Glenmark Pharmaceuticals Limited has clearly distinguished a bank guarantee from a corporate guarantee.

The Tribunal held that a bank guarantee available in the public domain may only be applied for comparability subject to certain adjustments. Therefore, judicious selection of external comparables based on specific facts is warranted.

The rate charged by the guarantor depends upon several factors such as the creditworthiness of the borrower, terms and conditions of the agreement, relationship with banks, history of the borrower, and so on. Each case must be analysed based on its own specific facts and circumstances.

The Rangachary Committee report on safe harbour for outbound loans and corporate guarantees has observed that the yield approach method and interest saving method, independently or in combination, are the most practical for the benchmarking of guarantee commission.

A special solution
Multinational companies often adopt a special purpose vehicle (SPV) route for outbound acquisitions. An SPV is often formed with very limited functions to raise fund overseas. SPVs are generally under-capitalised and rely on the parent company’s guarantee for raising funds overseas. Failure on the part of an SPV in raising funds would have a negative impact on the parent’s business.

In such a scenario, no services could have possibly been rendered for providing a guarantee. Instead, it may be considered that the parent acted in its self-interest in the capacity of a shareholder. Therefore, no payment of guarantee fee may be required.

In contrast to explicit guarantees discussed above, implicit guarantee works under the assumption that the association with a parent company would not lead to a default situation and that the parent would provide financial support at an opportune moment. Implicit guarantees, unlike explicit guarantees, are not legally enforceable.

No service would be considered to have been rendered by the parent to its subsidiary if, by reason of such affiliation alone, a subsidiary has a credit rating higher than in an unaffiliated scenario. It has been held in the landmark GE Canada ruling that the credit rating of a subsidiary company cannot automatically be equated with the credit rating of its parent.

Under specified domestic transactions, the guarantee transaction is akin to the above approaches but would depend on the applicability of each of the sections. Keeping in mind the ambiguity coupled with high transaction values, it would be advisable for companies to the avail the APA route or the safe harbour route for explicit outbound guarantee transactions.

Vishwa Sharan contributed to the article.

The article was published in The Hindu Business Line on 06 January 2013.