The paragraph of the OECD transfer pricing guidance on financial transactions dealing with parent guarantees is, in my view, incompatible with Dutch tax law and, if followed by other countries, could give rise to double taxation in certain situations. Absent any further guidance from the Dutch Ministry of Finance, Dutch guarantors of foreign affiliates’ debts and Dutch taxpayers borrowing with a foreign parent guarantee should carefully consider what the consequences of the OECD guidance will be for their finance structures.

OECD's Transfer Pricing Guidance on Financial Transactions

The OECD's report Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Action 4, 8-10, which will be added to the OECD Transfer Pricing Guidelines as a new Chapter X, contains a lot of interesting guidance. But there is one paragraph that particularly drew my attention and that is the paragraph called "Access to a larger amount of borrowing". It is part of Section D of the report, dealing with financial guarantees of borrowings by members of a multinational group.

The relevant paragraph deals with a situation where a member of a group borrows funds, the loan is guaranteed by a Parent Guarantor resident in another jurisdiction and, without the guarantee, the Borrower would not have been able to borrow the same amount.

The report suggests that it is possible that the borrowing should be bifurcated into a part that the Borrower could have borrowed on a standalone basis (the Standalone Amount) and a part that could only be borrowed because of the guarantee by the Parent Guarantor (the Guarantee Amount). The Guarantee Amount, the report suggests, should be treated for tax purposes as a loan by the lender to the Parent Guarantor, followed by a capital contribution by the Parent Guarantor to the Borrower. 

The result would be that the interest deduction at the level of the Borrower should be limited to interest on the Standalone Amount. The Parent Guarantor, should presumably be granted an interest deduction in its country of residence in respect of the interest attributable to the Guarantee Amount.

There is substantial authority that this is not the treatment that would apply under Dutch tax law.

Dutch guarantor of foreign affiliate’s debt

If the Parent Guarantor was a Dutch taxpayer and the Borrower foreign, the foreign Borrower would, for Dutch tax purposes, be considered to pay interest on the Guarantee Amount  to the Dutch Parent Guarantor and the Dutch Parent Guarantor would be considered to pay interest on that amount to the lender.

The Dutch Parent Guarantor would not incur any tax (except perhaps on a margin between interest deemed received and paid, and on an arm's length guarantee fee, but let's ignore that). The foreign Borrower, however, would not get an interest deduction in its country of residence with respect to interest paid on the Guarantee Amount, if the OECD guidance is applied. Hence, the interest on the Guarantee Amount would effectively not be deductible anywhere.

It is uncertain whether this form of double taxation can be solved under a mutual agreement procedure, because the guidance in the report is not binding on OECD member states.

Foreign guarantor of Dutch affiliate’s debt

No tax mismatch would arise in the case of a Dutch Borrower whose loan was guaranteed by a foreign Parent Guarantor. But this result would not follow from the application of the OECD guidance, but because the tax deduction for interest on the Guarantee Amount would be disallowed under the hybrid mismatch rules in the Netherlands. 

This would work as follows. 

For Dutch tax purpose, the Guarantee Amount would continue to be viewed as a loan to the Dutch Borrower, but the loan would be considered to have been made by the foreign Parent Guarantor rather than by the actual lender. (For Dutch tax purposes, equity treatment of the Guarantee Amount as suggested by the OECD report would only come into play in exceptional circumstances not relevant here.) 

Assuming that the foreign Parent Guarantor's jurisdiction follows the OECD guidance, the foreign Parent Guarantor would be seen as having made a capital contribution to the Dutch Borrower equal to the Guarantee Amount. The foreign Parent Guarantor would presumably treat the income from the deemed capital contribution as a tax exempt dividend and it would deduct the interest deemed paid by it on the Guarantee Amount. 

Given that, for Dutch tax purposes, the Dutch Borrower would be regarded as paying interest on the Guarantee Amount to the foreign Parent Guarantor, but the foreign Parent Guarantor would not recognize that income, the Dutch Borrower would be denied a deduction for the interest paid on the Guarantee Amount under the Dutch hybrid mismatch rules. (The Dutch Borrower would, however, be allowed an interest deduction for interest paid on the Standalone Amount.)

The result is that all of the interest is deducted once, in part by the foreign Parent Guarantor and in part by the Dutch Borrower. Apart from rate differences between the Netherlands and the country of residence of the foreign Parent Guarantor, no double taxation would occur. This result is consistent with the OECD report, albeit being achieved through a different set of rules.