On December 15, 2010, the Federal Court of Appeal dismissed the Crown’s appeal of the Tax Court of Canada decision in General Electric Capital Canada Inc. v. The Queen.1
The case considered whether the guarantee fee charged by General Electric Capital U.S. (GECUS) to its indirect subsidiary, General Electric Capital Canada Inc. (GECC), during the 1996-2000 taxation years was an arm’s length amount under the transfer pricing rules in the Income Tax Act (Canada) (the Act). GECC had borrowed for a number of years prior to 1996, always with an explicit guarantee from a member of the GE group. In 1995, following an internal review of these arrangements, GECUS began charging an annual guarantee fee to GECC equal to 1% of GECC’s outstanding debt.
The Minister of National Revenue (Minister) reassessed GECC in respect of the guarantee fee it paid for its 1996 to 2000 taxation years on the basis that financial support and other factors implicit in the non-arm’s length relationship between GECUS and GECC were sufficient to permit GECC to carry out its borrowing activities on the same terms and conditions as before 1996. Accordingly, the explicit guarantee provided no benefit to GECC and no guarantee fee should have been charged. The Minister disallowed GECC’s deduction of approximately C$136 million of guarantee fees and assessed additional non-resident withholding tax on the fees as if they had been distributed to GECUS as dividends.
THE TAX COURT DECISION
In a lengthy decision which reviewed the facts and circumstances and the evidence presented by 20 witnesses, 12 of whom were experts, the Tax Court held that the guarantee fees paid by GECC to GECUS were equal to or less than the amount required to satisfy the arm’s length principle in paragraph 247(2)(a) and its predecessor subsection 69(2) of the Act. Accordingly, the Court vacated the Minister’s assessments.
Relevance of Implicit Support and Other Non-Arm’s Length Factors
As a preliminary matter, the Court considered whether, and to what extent, implicit support and other non-arm’s length factors arising from GECC’s relationship with GECUS should be factored into determining, for purposes of the transfer pricing analysis, the hypothetical independent parties and the hypothetical transaction to be compared with the actual non-arm’s length transaction. The Court reviewed Canadian case law on the meaning of arm’s length and paragraphs 1.6 and 1.15 of the OECD Transfer Pricing Guidelines, which discuss the concept of independent parties and provide guidance on determining an arm’s length price by reference to the conditions that would have been obtained between independent enterprises in comparable transactions in comparable circumstances. Interpreting these principles, the Court rejected GECC’s position that the concept of implicit support should be ignored because it flowed from the non-arm’s length relationship between GECC and GECUS. The Court found that GECC’s position in the GE group and the implicit support afforded by its relationship with GECUS were economically relevant characteristics which should be taken into account in any description of an arm’s length hypothetical borrower. Further, the explicit guarantee was relevant, as it would impact the price negotiations between an arm’s length guarantor and the hypothetical borrower. The Court also found that in contrast to GECUS, which exerted control over GECC’s default risk because all treasury functions were centralized at GECUS’ head office, an arm’s length guarantor would assume more risk, thereby affecting the determination of an arm’s length price for the guarantee.
Transfer Pricing Methodology
As the three traditional methodologies (comparable uncontrolled price, resale price, and cost plus) could not be applied in the circumstances, the Court had to consider the alternative methodologies proposed by GECC and the Crown. Both of GECC’s proposed methodologies were rejected. The Court considered the guarantee insurance-based methodology to be unreliable in the circumstances, and concluded that the credit swap methodology was flawed in requiring an arbitrary assumption as to GECC’s credit rating in order to conduct the analysis.
The Court accepted the Crown’s assertion that the first step in the transfer pricing analysis was to calculate the value of the benefit enjoyed by GECC as a result of GECUS’ guarantee, which would be equal to the interest cost savings for GECC of guaranteed debt versus unguaranteed debt. The Crown’s yield method, which set credit ratings levels for GECC with and without an explicit guarantee, was also accepted to determine that interest cost savings.
However, the Court preferred the credit rating analysis of GECC’s expert to that of the Crown’s expert. GECC’s position was that its stand-alone creditworthiness, using the S&P rating criteria and methodology applicable in the years under appeal, would have been between B+ and BB-, when taking into account the benefits of the common GE name, GECUS’ management team and existing intercompany loans, its status as a new entrant in a very competitive market, and its thin capitalization, high leverage and decreasing profits. GECC’s credit rating without the explicit guarantee was then determined using a “bottom-up” approach that began with GECC’s stand-alone rating, which was then adjusted to take into account the value of support that could reasonably be anticipated from GECUS in the circumstances. In the view of GECC’s expert, the ratings agencies would have ranked GECC as an independent subsidiary of GECUS, i.e., GECUS would have been expected to provide little financial support to GECC if it did not explicitly guarantee GECC’s debt. In addition, GECC’s creditors and the ratings agencies would have noted a change in GECC’s financial support if the explicit guarantee were withdrawn since all of GECC’s indebtedness had been guaranteed from 1988. GECC therefore argued that its stand-alone rating might be raised only two or three notches by reason of its inclusion in the GE group such that its final rating would reasonably have been BB and at best BBB-.
In contrast, the Crown’s expert relied on a more qualitative approach to determining GECC’s credit rating which took into account certain forward-looking factors such as what management’s intentions and strategy were for GECC, the quality of GECUS’ management and GECUS’ credit reputation. The Crown’s expert also regarded GECC as a core or strategically important subsidiary despite its low proportion of assets on a consolidated basis. As such, the Crown’s expert concluded that it was appropriate to equalize the ratings of GECC and GECUS because a parent would be less likely to let a strategic subsidiary fail. The Crown preferred a “top-down” approach to determining GECC’s final credit rating based on the view that GECUS’ ownership of GECC was the most important factor. Under the Crown’s theory of reputational pressure, GECUS was dependent on the capital markets for financing and would do whatever was necessary to prevent a loss of market confidence in it.
Pricing of the Guarantee
While the Court accepted the Crown’s yield approach, it took issue with the Crown expert’s reliance on reputational pressure as a key factor for equalizing the credit rating of GECC and GECUS. In particular, the Crown’s argument of reputational pressure skipped over what the Court viewed as the essential first step in the ratings analysis: a determination of the stand-alone credit rating of GECC. GECC’s expert had performed a stand-alone rating analysis as prescribed by the methodology, which put him in a position to determine that there was a 12-13 notch differential between the stand-alone ratings of GECC and GECUS. Since the Crown’s expert had failed to conduct the critical first step in the analysis, he had no reference point for determining the credit ratings uplift provided by GECUS’ implicit support. Accordingly, the Court viewed the Crown expert’s opinion as “speculative at best”.
The Crown’s arguments also failed to adequately consider the impact that removal of the explicit guarantee would have on GECC. The Court accepted that the investment community and the ratings agencies would have reacted negatively to the removal of the guarantee, particularly since it had been in place since 1988. It also agreed with GECC’s position that the guarantee was needed to equalize the rating of GECC with that of GECUS, as sophisticated market participants would not accept a risk without the commensurate return that an explicit guarantee would provide. The Court therefore concluded that it was implausible that GECC could have raised the same amount of capital at the same low interest rates without the explicit guarantee, even if GECC’s debt had been rated AAA. Based on these findings, the Court concluded that GECC’s stand-alone credit rating should be in the range of B+ to BB- and that the typical ratings uplift for implicit support resulting from the GECUS/GECC relationship would have been two or three notches. Accordingly, the Court found that GECC’s credit rating without the explicit guarantee would have been in the range of BBB- to BB+.
The Court then considered whether a final adjustment was required to reflect certain potential benefits that the guarantee provided to GECUS, which the Crown argued would have enabled GECUS to negotiate a reduction in the guarantee fee. In the Court’s view, the yield approach already took into account several of the specific factors raised by the Crown, and other factors either offset each other or did not significantly affect the analysis, so no further rating adjustment was needed.
The Court accepted GECC’s calculations that the interest cost savings was approximately 1.83%. Reasoning that GECC could not be expected to pay 100% of its interest cost savings to an arm’s length guarantor, as it would then have had no economic incentive to enter into the guarantee, the Court concluded that the 1% guarantee fee paid by GECC to GECUS during the 1996-2000 taxation years was equal to or below an arm’s length price in the circumstances.
THE FEDERAL COURT OF APPEAL DECISION
The Crown’s appeal alleged that the Tax Court judge had made several errors of law, and had based certain conclusions on erroneous findings of fact. The Crown also relied on the Federal Court of Appeal’s recent decision in Heron Bay Investments Ltd. v. The Queen 2 to argue that it had been deprived of its rights to natural justice and procedural fairness insofar as the Tax Court judge introduced his own theory of the case that became the linchpin for his decision, thereby creating a reasonable apprehension of bias.
Implicit Support Relevant in Determining Arm’s Length Price
In its reply to the Crown’s notice of appeal, GECC argued that even if the Tax Court judge had made the errors alleged by the Crown, the appeal should be dismissed because the judge had misapplied the transfer pricing rules by factoring implicit support, a by-product of the non arm’s length relationship between GECC and GECUS, into the determination of the arm’s length price for the guarantee. Although the Court was not required to consider this issue since it dismissed each of the Crown’s specific grounds for appeal, it did so because the issue went to the “core of the decision”.
In the Court’s view, the Tax Court judge did not err in concluding that GECUS’ implicit support of GECC could be considered when applying the transfer pricing rules:
The concept underlying [the transfer pricing rules] is simple. The task in any given case is to ascertain the price that would have been paid in the same circumstances if the parties had been dealing at arm’s length. This involves taking into account all the circumstances which bear on the price whether they arise from the relationship or otherwise.
This interpretation flows from the normal use of the words as well as the statutory objective which is to prevent the avoidance of tax resulting from price distortions which can arise in the context of non arm’s length relationships by reason of the community of interest shared by related parties. The elimination of these distortions by reference to objective benchmarks is all that is required to achieve the statutory objective. Otherwise all the factors which an arm’s length person in the same circumstances as [GECC] would consider relevant should be taken into account.
In the present case, it is common ground that in the context of the yield method, implicit support is a factor which an arm’s length person would find relevant in pricing the guarantee. It follows that it had to be considered. The suggestion that implicit support should be ignored would require the Court to turn a blind eye on a relevant fact and deprive the transfer pricing provisions of their intended effect.3
As support for its conclusion, the Court referred to the comparable transactions in comparable circumstances” test in paragraph 1.6 of the OECD Transfer Pricing Guidelines4 and the Court’s recent transfer pricing decision in GlaxoSmithKline Inc. v. The Queen (leave to appeal pending before the Supreme Court of Canada)5, in which it held that the Tax Court had erred in failing to consider all of the relevant circumstances in determining whether the taxpayer had paid an arm’s length price for bulk active pharmaceutical ingredients purchased from its non-arm’s length foreign supplier.
The Court also found no error in the Tax Court judge’s conclusion that the assessment of the benefit conferred by the explicit guarantee was an acceptable way of determining whether an arm’s length party would have paid a guarantee fee to GECUS.
No Material Error of Law or Fact
The Federal Court of Appeal did conclude, however, that the Tax Court judge had erred in considering a scenario in which the explicit guarantee was withdrawn, since the purpose of the yield approach was to measure the benefit to GECC of the explicit guarantee as compared to implicit support. Nevertheless, the error would not have changed the Tax Court judge’s conclusion, since it hinged upon the report of GECC’s expert in which the impact of the guarantee’s removal was only a minor consideration. In the Court’s view, this was not a close case where a single factor could alter the outcome of the case. Similarly, the failure of the Crown’s experts to consider the impact of the removal of the guarantee was only one of several factors referred to by the Tax Court judge in rejecting their testimony. Accordingly, the Court concluded that the error had no impact on the Tax Court judge’s finding that a gap existed between the credit rating of GECC with and without the explicit guarantee, and that the 1% guarantee fee fit within this gap. The Court noted that the existence and extent of the gap was also corroborated by two exploratory quotes GECC obtained in 1995 from two Canadian banks as to GECC’s stand-alone credit rating.
Turning to the Crown’s assertion that the Tax Court judge had erred in finding that GECC would be unable to obtain back-up lines of credit without an explicit guarantee, which it based on the fact that GECC had obtained the two exploratory quotes regarding its stand-alone credit rating, the Court concluded that the finding was open to the judge on the evidence. As the quotes were only exploratory, they were insufficient to establish that GECC would have had the back-up facilities necessary to obtain unguaranteed debt in the same amounts without explicit parental support. In any event, the quoted rates were more than 1%, so any error would not have affected the Tax Court judge’s conclusion that the 1% guarantee fee was an arm’s length fee.
No Reasonable Apprehension of Bias
While the Federal Court of Appeal concluded, based on the trial record, that the Tax Court judge had engaged in excessive questioning regarding the removal of the explicit guarantee and its negative impact on GECC’s credit rating, it did not amount to a reasonable apprehension of bias against the Crown. The Court pointed out that, in contrast to the situation in Heron Bay, it was GECC’s expert (and not the Tax Court judge) who introduced the withdrawal of the guarantee as a relevant consideration for the determination of GECC’s credit rating. Furthermore, as discussed above, the finding that the withdrawal of the guarantee was relevant played only a minor role in the judge’s conclusion. According to the Court, the judge’s excessive questioning simply showed that he “became overly concerned about an issue that had no substantial connection with the outcome”. The Court also tersely dismissed the Crown’s assertion that the Tax Court judge’s reasons prevented meaningful appellate review.
The Federal Court of Appeal’s decision has confirmed that the yield approach is an acceptable method of determining the arm’s length price for a cross-border guarantee between non-arm’s length parties under Canada’s transfer pricing rules. Perhaps more significant, however, was the Court’s obiter commentary affirming the Tax Court judge’s conclusion that implicit support was relevant in the circumstances to determine the arm’s length price for the explicit guarantee. The practical implication of this case is that Canadian taxpayers who pay cross-border guarantee fees to non-arm’s length parties will need to factor into their transfer pricing analysis the potential impact of implicit support, which may increase the complexity as well as the costs of that analysis.
It remains to be seen whether the Courts’ conclusion regarding implicit support may have broader application to other types of non-arm’s length cross-border arrangements, although this case and the Court’s prior decision in GlaxoSmithKline suggest that despite the fact that implicit support and other affiliation benefits received by a taxpayer flow from the taxpayer’s non-arm’s length relationship with its affiliates, they will be relevant to the transfer pricing analysis where they form part of the taxpayer’s “business reality”.