Untangling the Transfer Pricing challenges with Corporate Guarantee and Letter of Comfort

One key topic currently under discussion is whether the transaction pricing should be based on an actual benchmarking or whether the 1% valuation issued by the GST authorities will prevail. In this regard, a better view seems to be that the 1% valuation is merely for the purposes of payment of GST. However, the actual transaction should be undertaken based on the appropriate benchmarking methods.

Transfer Pricing (TP) regulations examine related party transactions, scrutinising their alignment with arm’s length principles (market valuation) from both tax leakage and corporate governance perspectives. An important area of contention lies in applying the arm’s length compensation for the issuance of corporate guarantees (CGs) and letters of comfort (LoC), sparking debates in income tax proceedings and audit committee deliberations.

In essence, a CG/ LoC serves as a financial assurance mechanism for lenders, typically accompanying significant financial transactions within a group. While a CG entails explicit financial obligations upon the guarantor in case of borrower’s default, an LoC operates as a supportive declaration by the group’s flagship entity, not carrying any direct financial obligation.

The varied interpretations by tax and judicial authorities on whether such arrangements qualify as ‘covered transactions’ under TP regulations have further complicated the debates. Similarly, debates have emerged within the domain of Goods and Services Tax (GST) in India regarding the valuation and applicability of GST on such transactions.

Recent developments

Recently, the Mumbai Income Tax Appellate Tribunal (ITAT) issued two specific rulings on the issue. While the ITAT in the Asian Paints Limited case deemed that an LOC meets the criteria of an international transaction necessitating compensation, the Lupin Limited case held otherwise, emphasising the implicit nature of liability in LoCs.
Additionally, the GST authorities issued a circular clarifying that the value for a CG should be 1% of the guaranteed amount or the actual consideration, whichever is higher.

Key takeaways from the above rulings

In a nutshell, the critical differentiator in ascertaining whether a consideration needs to be charged would be whether the support in question is explicit or implicit based on the facts of the case. If the support casts a financial liability on the guarantor or issuer of the letter of comfort, compensation may be required.

Pricing from a TP and GST standpoint

Once it is established that compensation is required, determining the quantum of such compensation becomes critical.
From a TP perspective, it is a matter of benchmarking by adopting various methods for conducting analysis. Globally, the Interest Savings Method (ISM) and Loss Given Default (LGD) approach are widely accepted. The ISM argues that since the credit rating of the guarantor gets superimposed on the borrower, the borrower is able to obtain the funds at a reduced interest rate. The LGD method takes into account the probability of default by the borrower triggering payout for the guarantor and the likelihood of non-recovery of the said payout by the guarantor from the borrower. Apart from these, even directly comparable transactions/ quotations having identical terms and conditions can be adopted for benchmarking.

One key topic currently under discussion is whether the transaction pricing should be based on an actual benchmarking or whether the 1% valuation issued by the GST authorities will prevail. In this regard, a better view seems to be that the 1% valuation is merely for the purposes of payment of GST. However, the actual transaction should be undertaken based on the appropriate benchmarking methods. Having said that, the TP rules themselves recognise that Government orders in force need to be taken into account while determining the related party pricing. Hence, one may argue that the 1% itself is an appropriate transaction pricing.

Given the recent developments, it is crucial to consider the facts and circumstances involved in each individual case in examining the transaction. The nomenclature of the instrument or terminology used in the financial statements should not be the sole determining factor.

Further, whether the 1% guidance provided by the GST Circular or the actual benchmarking should be the basis of the price determination is also a subject matter of debate. A clarification to this effect from the Government would be welcome.