Benchmarking of corporate guarantees and/or performance guarantees

One of the readers of the blog asked to discuss an appropriate and practical methodology for benchmarking corporate and/or performance guarantees. Further the reader states: Pen

“From the material I have been able to read till now, the interest saving approach discussed in the GE Canada judgment is one way to do it. Theoretically, the risk of loss approach also sounds plausible. However, I am not too convinced with the formula that ought to be used for computing the risk of loss for the guarantor. The formula broadly reads as follows:

Return on capital at risk = Probability of default*Amount guaranteed*Guarantor’s cost of capital.”

The reader’s concern is that “if the guarantor is a large multinational company, the cost of capital would be really high and availing of guarantee would not seem like a good option from the subsidiary’s perspective, as it would just be better to borrow from the market.”

Therefore the reader is concerned whether “the formula mentioned above would actually be useful for computing a guarantee fee in a real life benchmarking scenario.”

Please note the above are the comments of a reader of the blog and are not mine, however, as the topic is very interesting I thought I share it here and get everyone’s input.

In relation to the above I would like to note that a corporate guarantee and a performance guarantee are two very different guarantees and require a different approach.

From the GE Canada case it was held that a “yield approach” is the correct methodology to be applied for the specific facts and circumstances in the case (this was in relation to a corporate guarantee). The yield approach is meant to estimate the total potential interest rate savings achieved by the borrowing entity as a result of the explicit guarantee. The yield approach is applied in two steps – 1.) estimating the stand-alone credit rating and then notching that credit rating for the affect of the parent-subsidiary relationship and 2.) looking at the spread in corporate bond yields between the parents credit rating and the estimated credit rating of the subsidiary.

From a performance guarantee perspective there are different approaches which may have some estimations. I will do some more research before commenting on this in detail but I hope to get some more information from all of you out there in relation to the above.

Please continue sending your comments and concerns for any transfer pricing topics and hopefully we can have many more blog posts like this.

What are your thoughts?

This site uses Akismet to reduce spam. Learn how your comment data is processed.