Various tax and corporate laws have been increasingly regulating related party transactions. With increased participation of investors and other stakeholders, it is important to ensure that such transactions are carried out with complete transparency, at arm’s length price and after obtaining necessary approvals. One of the common transactions between group entities can be observed in the form of financial corporate guarantees provided by one entity to another group entity to boost its credibility. For a better understanding, it is an arrangement wherein one of the entities agrees to act as a guarantor for another group entity while seeking funds from a financial institution.
Corporate guarantee (CG) arrangements are emerging as complex topics to comprehend under indirect tax laws and transfer pricing (TP). Often, these transactions are undertaken without consideration due to which tax authorities are becoming watchful when it comes to reporting and taxability of these arrangements. As the tax administrative ecosystem has become agile, taxpayers may face challenges in determining taxability and valuation of such arrangements.
Understanding indirect tax aspects
Prolonged dispute since the service tax regime
Under service tax law, two elements, i.e., ‘activity’ and ‘consideration’ were necessary to classify a transaction as a ‘service’ and there was no deeming fiction for related party transactions. The same argument has been considered in a recent landmark judgment wherein the Hon’ble Supreme Court (SC) in the matter of M/s Edelweiss Financial Services Limitedhas held that service tax is not leviable on the CG in absence of any consideration. The SC stated that consideration is must for levying service tax on CG and thereby, upheld the order of Customs, Excise and Service Tax Appellate Tribunal (CESTAT) in said matter. This is a significant ruling that would be referred as precedence in other similar cases and will help to resolve long-drawn litigations on this issue under the erstwhile service tax regime.
In contrast to the above scenario, it is equally important to analyse where consideration exists for providing CG to a group entity. Prima facie, such transactions should have been taxable under service tax regime as the activity of providing CG against consideration would qualify as ‘service’. However, divergent views have been taken by different benches of CESTAT in such cases. For instance, in the case of M/s Olam Agro India Ltd., Delhi CESTAT upheld the demand of service tax on the CG commission and pronounced that “the commission paid was taxable under ‘Business Auxiliary Service’. Merely because the name of the guarantee has been changed from ‘Bank’ to ‘Corporate’ it cannot be said that it won’t fall under ‘Business Auxiliary Service’ as defined under Section 65 (105) of the Finance Act, 1994.” Though, said matter is pending for disposal before the apex court.
On the other hand, Chennai CESTAT held in favor of taxpayer in the case of M/s Sterlite Industries India Ltd. The bench took a view that “The corporate guarantee that was entered into by appellant is only for the limited purpose of securing loans to its subsidiaries. Corporate guarantees are issued in order to safeguard the financial health of their associate enterprises and to provide it support. For banks, providing bank guarantee is part of their regular course of business and they charge rate on the higher side.”
Such inverse decisions have created doubts about the taxability of CG in those cases where consideration exists. The same may have a bearing on litigations pending in the erstwhile regime and transactions undertaken by taxpayers under Goods and Services Tax (GST) law.
Uncertainty continues under GST regime
Unlike service tax regime, GST law has a deeming fiction that assumes that an activity between related parties would qualify as supply even if consideration does not exist. Accordingly, GST would be leviable in such cases.
Under GST, divergent views are available for taxability of CG arrangements. One of the aspects which supports taxability of CG is that the decision of SC under service tax regime was pronounced in favor of the taxpayer only on the premise that provider of CG did not charge consideration. Accordingly, even if the consideration does not exist for such arrangements under GST regime, Schedule I to CGST Act, 2017 would still hold it as a deemed supply under GST law. Further, circular no. 34/8/2018- GST dated 01 March 2018 also clarified that the services provided by Central or State Government by way of guaranteeing the loan taken from financial institutions against consideration in any form, including guarantee commission, shall be taxable.
However, as per an alternate view, CG may fall under the definition of actionable claim, and therefore such an arrangement should be outside the ambit of supply as per Schedule III to the CGST Act. An actionable claim represents beneficial interest in movable property that is not in possession. It is an entitlement to a debt and the holder of the actionable claim enjoys the right to demand ‘action’ against any person.
Challenges in determining valuation of corporate guarantee transaction
GST law provides a separate rule to determine value for related party transactions. As per said rule, the value of such transactions shall be its open market value (OMV), if available. In other cases, it shall be the value of supply of goods or services of like kind and quality. It is pertinent to note that CG arrangements are not usually spotted between unrelated parties and generally exist between related entities only. Accordingly, OMV may not be ascertainable for CG. However, reference may be drawn from service of ‘bank guarantee’ (BG) provided by financial institutions which may be considered as like kind and quality for CG arrangements. In such arrangements, financial institutions charge a given percentage (as a commission) of the amount of BG issued and discharge GST on commission charged from customers. Percentage of commission used for BG purposes may be considered for valuation of CG arrangements.
It is of utmost importance to note that commission rates applicable on BG are determined based on combination of various factors such as borrowing capacity, credit rating, loan amount, tenure of loan etc.
These factors may not be easily discernible in CG arrangements since the same are not usually carried out in the normal course of business of a parent entity. Accordingly, it may be challenging to adopt a particular valuation basis commission charged for BG. Wherever possible, reference may be drawn from principles adopted to calculate arm’s length price for the purpose of TP provisions under Income Tax Act, 1961.This methodology has been explained in brief in subsequent paragraphs.
Though, as per the provisions of GST law, where the recipient is eligible for full input tax credit (ITC), the value declared in the invoice shall be deemed to be the OMV. Thus, in such situations, one may adopt a reasonable value to discharge tax on CG transactions.
Overview from a transfer pricing perspective
The issue of CG provided by Global Multinational Enterprises (MNE’s) to financial institutions with respect to the loans availed by subsidiaries /Associated Enterprises (AE) has been one of the most contentious issue in financial transactions arena. The following questions need detailed analysis when dealing with CG:
whether there is any implicit benefit which an entity receives by being part of a group; whether an explicit guarantee can be considered as a shareholder activity or a service;
The cost that may arise due to provision of guarantee; probabilities of the financial institution granting a loan without guarantee, etc.
These have been discussed in detail below:
Implicit support: Implicit support in CGs refers to the unwritten commitments and assurances provided by a parent company to a subsidiary or affiliate when guaranteeing its financial obligations such as parent companies extending “letter of comfort” or “letter of intent” to the lenders of the Group Company.
Explicit Financial Guarantee: When a group company provides explicit financial guarantee to its subsidiary, it is important to evaluate whether this is a shareholder activity. Shareholder activity is an activity which is performed by a member of an MNE group solely because of its ownership interest in one or more other group members, i.e. in its capacity as shareholder.
Historically, the litigation surrounding provision and receipt of corporate guarantees centered around whether CG is a shareholder activity.
The Finance Act 2012 vide amendment to Section 92B of the Act included guarantee transaction as international transaction under broader category of capital financing with a retrospective effect by appending clause “c” to explanation (i) in Section 92B of the Act, thereby requiring an arm’s length charge. With this change in definition, corporate guarantees were squarely covered and classified as international transactions.
A charge for such a corporate guarantee
Post this change, most tribunals upheld that provision of corporate guarantees mandates a charge or a CG fee.
The OECD’s TP Guidance on Financial Transactions sets out “yield approach” as one of the approaches that can be used to determine/benchmark guarantee fees. This approach quantifies the guaranteed party's benefit from the guarantee in terms of lower interest rates. The benefit is calculated as the difference between the cost to the borrower after considering the benefit of the explicit guarantee.
The UN TP manual states that at arm’s length, a company would not take on the extra cost of a guarantee unless that guarantee makes the overall cost of finance cheaper than it would be on a stand- alone basis. The borrowing rates can be estimated by obtaining market data about transactions between unrelated companies with similar characteristics to the borrower (e.g., similar borrowing capabilities and credit worthiness).
The other methodologies that have also been acknowledged by OECD TP Guidelines and UN TP Manual are as follows:
- Controllable Uncontrolled Price Method – Under this method, guarantee rates are directly compared based on the availability of data for independent transactions.
- Cost Approach – This method focuses on the cost to the guarantor of providing the guarantee. Cost approaches quantify the additional risk the guarantor bears or the value of the expected loss that the guarantor would incur by providing the guarantee.
Understanding the Indian context
Even today, after the change in definition of international taxation, a few taxpayers continue to not charge any guarantee fee or charge a very insignificant amount as a guarantee fee contending that it is a shareholder activity. Some other taxpayers determine the rate of corporate guarantee on an ad hoc basis, or by relying on judicial precedence without taking into cognizance the facts of the case.
CG transactions being litigative in nature; a detailed documentation showcasing the nature of corporate guarantee, their purpose (whether shareholder activity or service), utilisation of funds, detailed benchmarking analysis, quotes from financial institutions, other comparable data etc. should be maintained by the taxpayers.
In our experience, the TP officer usually challenges these ad hoc determinations of CG and benchmarks this transaction by using a higher fee rate or by comparing them to bank guarantee rate, which is usually on a higher side.
Currently, the litigation around corporate guarantee is focused on arm’s length pricing. A general observation from the various tribunal decisions is that a corporate guarantee fee between 0.5% to 0.85% has been considered to be at arm’s length.
The Bombay High Court in case of Everest Kento Cylinders Ltd1 and Manugraph India Ltd2 adjudged that based on the facts of the case, a corporate guarantee fee of 0.50% was arm’s length. However, the Madras High Court in the case of Redington (India) Limited3, held that based on the case facts, a corporate guarantee fee of 0.85% was arm’s length. There has been a plethora of decisions from various Income Tax Appellate Tribunals upholding the corporate guarantee fee at 0.50%
Further, for provision of corporate guarantee, Rule 10TD of the Indian Income Tax Rules, 1962, provide a rate of 1% of the guaranteed amount as the safe harbour rate. Safe harbour is defined as circumstances in which the tax authority shall accept the transfer price declared by the taxpayer to be at arm's length.
From the above discussions, it can be gathered that taxability and valuation of corporate guarantee is clouded by uncertainties. Recently, notices have been issued by various field formations such as DGGI and GST Audit groups demanding applicable GST on corporate guarantee. Given the same, most taxpayers have already started analysing impact of GST provisions on such arrangements.
It would be critical to determine the appropriate fee for corporate guarantees by documenting the economic substance and commercial rationale of the guarantees, valuing them using appropriate methods, and ensuring that the terms of the guarantees are consistent with arm's length principles. Robust documentation will further help the taxpayers mitigate risks from TP and GST perspectives and avoid disputes with tax authorities.
This article first appeared in Taxsutra on 21 September 2023.
- T.C.A.Nos.590 & 591 of 2019