The Tax Court of Canada's recent decision in General Electric Capital Canada Inc. v. The Queen provides an example of the court's application of transfer pricing rules in the Income Tax Act (Canada) (the "ITA") in the context of a guarantee arrangement between a non-resident parent and a Canadian subsidiary. In this case, the Canada Revenue Agency denied the deduction of $136 million in guarantee fees paid over several years by General Electric Capital Canada Inc. ("GEC") to its US-based parent. The court found that the guarantee fee of 1% per annum of the principal outstanding debt amount did not exceed an arm’s length price. Consequently, the court ruled in favour of GEC and allowed the deduction.


Taxation of Guarantee Fees

Generally, a guarantee fee is a deductible expense for tax purposes. For taxation years starting 2008, a guarantee fee paid by a resident to an arm’s length non-resident is free of withholding tax, subject to certain exceptions. In a case of a non-arm’s length guarantor, guarantee fees will be subject to a withholding tax if treaty relief is not available. As a result of the 2008 changes to the Canada - United States Income Tax Convention, guarantee fees can be paid free of any withholding tax to a non-arm’s length person entitled to treaty benefits for taxation years after 2009, subject to certain exceptions.

Guarantee fees are generally taxed as part of guarantor’s income by its home jurisdiction. If tax rates of the guarantor country and the borrower country are comparable, such as in Canada-US cross border context, there may not be any overall tax savings by paying guarantee fees to a related guarantor. However, if the borrowing corporation does not pay an arm's length fee to the related guarantor, there may be a risk of double taxation resulting from the application of transfer pricing rules.

Transfer Pricing Rules

Transfer pricing rules in the ITA can apply to effectively adjust the quantum of a payment in a non-arm’s length transaction for tax purposes where the terms of the transaction differ from those that would have been made between parties dealing at arm’s length. Consequently, if a guarantee fee used in a transaction between non-arm's length parties exceeds an arm’s length price, the deduction will be reduced.

In addition, a penalty may be applied under the ITA if the amount of the transfer pricing adjustment exceeds the lesser of 10 percent of the gross revenue of the taxpayer in the year and $5 million, and it is established that the taxpayer has not made reasonable efforts to prepare contemporaneous documentation in accordance with the ITA.

General Electric Capital Canada


In this case, a US-based parent General Electric Capital Corporation ("Parent") guaranteed debt securities issued by a Canadian subsidiary GEC in consideration for a guarantee fee equal to 1% per annum of the principal amount of debt securities outstanding during a year. The Minister disallowed the deduction of a total of $136 million in guarantee fees paid to the Parent during its 1996 to 2000 taxation years.

Position of the Minister of National Revenue

The Minister argued that the guarantee provided no economic benefit to GEC and, therefore, its arm’s length price would have been nil. GEC enjoyed a so-called "implicit support" from its Parent. The Parent could never allow its like-named affiliate, such as GEC, to default on its debt because it would damage the Parent’s own AAA credit rating and increase its borrowing costs significantly. Due to this "implicit support" GEC would have had the same credit rating, could have borrowed the same amount of money at the same interest rate without the guarantee.

The Minister also added 5% withholding tax to the guarantee payments on the basis that the payment of the guarantee fees was deemed to be a payment of dividends which should be subject to withholding tax.

Position of GEC

GEC argued that it paid an arm’s length price for the guarantee. The transfer pricing rules invite the court to analyse a transaction between related entities as though they were unrelated parties. Consequently, all distortions that arise from the parties’ non arm’s length relationship, such as "implicit support," must be ignored and the Minister’s position is unfounded.

GEC argued that the Minister’s approach is flawed because it did not adduce evidence on what would be a price of a comparable arm’s length guarantee arrangement, as required by the transfer pricing rules; the basis of the Minister’s position was simply that the guarantee was not necessary in GEC’s business.

Finally, GEC presented expert evidence that without the guarantee its credit rating would have been BB as opposed to AAA and its cost of borrowing would have been higher.

The Decision

In a lengthy and complicated judgement and after taking into account several expert opinions, the Tax Court of Canada determined that that the guarantee fee did not exceed an arm’s length price.

The court held that the factor of "implicit support" is relevant in an arm’s length analysis under the transfer pricing rules. It also noted that transfer pricing rules can apply if the value of the benefit received from a transaction is nil and, consequently, the transaction cannot be compared with an arm’s length transaction.

In its analysis, the court compared the borrowing cost of guaranteed debt as opposed to the borrowing cost of unguaranteed debt. By relying heavily on expert witnesses, the court determined that:

  1. GEC’s stand-alone credit rating without the guarantee and without the "implicit support" from the Parent would have been B+ to BB-;
  2. When the factor of "implicit support" from the Parent is taken into account, GEC’s rating without the guarantee would only go up to BBB-/BB+; and
  3. The GEC’s interest cost savings afforded by the guarantee was approximately 1.83%. In this regard, the court also took into account that GEC’s investors would not welcome the removal of the guarantee and would not have the same confidence in unguaranteed debt. The court recognized that the guarantee existed for many years and served a bona fide business purpose. The "implicit support" of the Parent could not replace the need for a guarantee as few investors are foolish enough to believe that the it is equivalent to a guarantee.

Based on this evidence, the court concluded that the 1% guarantee fee did not exceed an arm’s length price because GEC "received a significant net economic benefit from the transaction."

The case is currently under appeal to the Federal Court of Appeal. The Federal Court of Appeal decision will undoubtedly be an important development in the law of transfer pricing in Canada.