On December 4th, 2009, The Tax Court of Canada (herein referred to as “TCC”) ruled on one of Canada’s most significant cases to date regarding guarantee fees, the case of General Electric Capital Canada Inc. (herein referred to as “GEC”). In the case, the TCC found in favor of GEC regarding the payment of guarantee fees to its parent, General Electric Capital Corporation (herein referred to as "GEUS") for guaranteeing GEC’s debt to third parties. GEC paid GEUS guarantee fees of over $135 million during the 1996 through 2000 taxation years.
The arm's length nature of the payment by GEC to its parent was at issue. The Canada Revenue Agency ("CRA") audited GEC's guarantee fee and determined that an arm's length person would not have paid for the guarantee as it provided no benefit. GEC disagreed, asserting that the guarantee reduced its borrowing costs.
The decision by the CRA to take such a rigid position is surprising given that the CRA has assessed and negotiated inbound and outbound guarantee fees in the past with fees ranging widely in size. Surely the CRA understands that the application of guarantee fees is a commercial reality in the day to day running of a multinational corporation. While the TCC’s decision was no doubt the correct one, the more interesting question is why the CRA chose to take such a rigid approach when the facts of the case suggested otherwise. This article provides an overview of the case and suggests why, given the facts and circumstances, the CRA chose to deviate from the arm’s length principle. An interesting question arises as to whether the CRA proceeded based on principles, or due to the size of the adjustment.
This case involved an American parent company, GEUS, and its wholly-owned, indirect Canadian subsidiary, GEC. GEC and GEUS did not deal with each other at arm’s length during the years under appeal. During this time, GEC was a financial services company operating in Canada. GEC’s operations essentially consisted of borrowing funds from the capital markets at low cost, and then turning these funds into profits by lending or leasing to other parties. In order to implement this business model, substantial amounts of capital were obtained by GEC by issuing debt in the form of commercial paper and unsecured debentures. The exclusive purchasers of GEC’s debt securities were third parties unrelated to GEC or GEUS.
GEUS guaranteed GEC's debt prior to 1995, however, GEUS only started charging GEC for the guarantees in 1995. Written agreements were entered into by GEC and GEUS concerning the guarantee fee (herein referred to as the “Guarantee”). GEUS agreed to guarantee GEC’s debt securities in return for the payment of a fee equal to 1%, or 100 basis points, per annum of the principal amount of the debt securities outstanding from time to time during a year. The fee was deducted by GEC for the 1996 to 2000 taxation years.
The Minister of National Revenue (herein referred to as “MNR”) reassessed GEC because it believed that GEC had obtained no economic benefit from the Guarantee. MNR was of the opinion that the arm’s length price of the Guarantee should be zero. The TCC was tasked with determining the arm’s length price for the Guarantee.
Standard & Poor’s and Moody’s Investors Service, two credit rating agencies based in the United States, assigned an issuer rating of AAA to GEUS, the highest issuer rating assigned by them. GEC also received the highest credit quality ratings by two Canadian based credit agencies. The consensus between GEC’s representatives and experts is that the AAA investment rating for GEC’s debts would not have been possible without the Guarantee.
At trial several experts explained their findings based on different methodologies. The TCC concluded that the yield curve approach provided the best method to determine the Guarantee fee. This approach is a reflection of the expenses incurred when borrowing money given different maturities and credit ratings. It compares the interest rates that GEC could obtain when borrowing money with the Guarantee, versus without the Guarantee.
According to GEC, the yield approach determined that the spread was between 100 and 300 basis points, or 1 to 3%. In general, experts for GEC analyzed the spread between AAA- rated bonds, and bonds that are an average of single B and BB. One expert concluded that the overall spread was about 352 basis points between a AAA rating and the B+ to BB- rating for GEC in the absence of an explicit guarantee. Therefore, the value of the Guarantee was determined to be approximately 1.83% based on a BB+ to BBB- credit rating range.
GEC’s experts assigned a B+ to BBB- credit rating to GEC as a stand-alone entity for various reasons. GEC was a profitable entity growing rapidly in a very stable marketplace. However, GEC was thinly capitalized, and had a high degree of leverage. GEC’s profitability was also decreasing during the period in question. Despite GEC’s reduced leverage and rapid growth, it was unable to generate profits or increasing profits on a continuous basis. Further, GEC was part of an intensely competitive environment. Experts claimed that, in general, when a weak entity is owned by a strong parent, the entity will often receive a stronger rating than it would on a stand-alone basis. Some experts were of the opinion that GEC was only able to borrow the amount of funds it did in the Canadian commercial paper market because of the Guarantee from GEUS.
The GEC experts' opinions were also influenced by the fact that GEUS had provided a guarantee since 1988 for no charge until 1996.
One of MNR’s experts used a quantitative approach to measure the creditworthiness of GEC. This approach is generally based on financial market data, such as stock prices, bond prices and CDS spread. He determined that GEC was a core subsidiary of GEUS, and should thus receive a AAA rating. At the very least, GEC could have been rated AA if classified as having been strategically important to GEUS at the relevant time, rather than of core importance. As a result, in the opinion of the MNR's expert, the fee would have been between 15 and 24 basis points. He therefore classified the 1% fee as a very high-risk adjusted return on capital.
GEC claimed that all distortions that arise from the parties’ relationship must be eliminated to arrive at an arm’s length result. GEC believed that its credit rating prior to the implementation of the Guarantee should be determined on a stand-alone basis without factoring in GEUS’s credit rating. GEC’s evidence showed that GEC’s credit rating on a stand-alone basis is, at best, BB for the relevant years. The yield approach determined that, under these circumstances, GEC’s economic benefit from the Guarantee exceeded the fee paid to GEUS.
MNR claimed that, in the absence of the Guarantee, GEC’s credit rating should be equal to the one of GEUS by reason of their affiliation. MNR believed that GEC could have borrowed at the same interest rates with or without the Guarantee, and therefore did not receive an economic benefit from the Guarantee. MNR claimed that the Guarantee was simply a confirmation of GEUS’s preexisting support in favour of GEC, and that no fee should have been charged.
TCC Decision & Analysis
The TCC believed that GEC’s counsel incorrectly applied the arm’s length principle when they suggested that the concept of “implicit support” should be ignored because it is rooted in the non-arm’s length relationship. However, the TCC also stated that:
Implicit support is nothing more than one’s expectation as to how someone will behave in the future because economic reasons will cause the person to act in a certain manner. Economic circumstances can change quickly, as evidenced by the recent credit market meltdown. A guarantee is a much more effective form of protection. It is something that investors in the present case would have been reluctant to give up in light of the fact that substantially all of [GEC]’s debt had been guaranteed for a very long period of time.1
The TCC agreed with GEC’s experts’ testimony that the removal of the Guarantee would have elicited negative reactions from the investment community and the rating agencies. It also concluded that the evidence did not show on a balance of probabilities that the unguaranteed debt of GEC would be rated close to AAA. The TCC stated that, despite the implicit support of GEUS towards GEC, it would be an unwarranted leap of faith to conclude that GEC’s credit rating would be equalized with that of GEUS if the Guarantee was not in place.
The TCC did not accept the testimony of MNR’s only expert who provided evidence as to the market price of the Guarantee because he did not consider the impact of the removal of the guarantee and failed to perform a stand-alone rating in his initial report. He also incorporated the wrong risk capital requirement and failed to consider the rate of return on the risk capital, which is required as compensation for expected loss. By only allowing a charge for expected loss, the expert did not allow for a return in the form of profit. Therefore, the method he employed only allowed the guarantor to recover its cost. This is not an accurate assessment for companies operating in an arm’s length world, where a service is generally provided for profit. The TCC concluded that GEC’s final credit rating without explicit support would be in the range of BBB /BB+.
The TCC concluded that:
Under the yield approach, the interest cost savings based on the rating differential between BBB /BBB+ and AAA, the latter being the rate achieved with the GEUS guarantee in place, work out to approximately 183 basis points or 1.83%. I am of the view that a 1% guarantee fee is equal to or below an arm’s length price in the circumstances, as the Appellant received a significant net economic benefit from the transaction. The net economic benefit exceeds the 1.83% calculated under the yield approach. Without a guarantee, the Appellant would have been unable to procure standby letters of credit in an amount sufficient to cover its commercial paper program.2
With regards to the Part XIII withholding tax, this tax was not sustainable in light of the TCC’s conclusion that the fee paid by GEC did not exceed the amount of an arm’s length price.
At the very heart of transfer pricing is the notion that intercompany prices between related parties be set as if the parties were independent of one another. This principle is enshrined in the OECD guidelines on transfer pricing, which the CRA generally adheres to. The CRA adjustment that led GEC to court is troubling on a number of levels, especially given the fact that certain transfer pricing principles, namely the idea that prices be set to represent arm’s length standards, were ignored.
The CRA's position is unfortunately another example of where the Agency did not follow its own principles or past decisions, and decided to take a tough stance based on the pure quantum of the adjustment. The CRA must be more consistent in the manner in which they approach transfer pricing, in particular in respect of guarantee fees, considering it has accepted guarantee fees in the past on both an inbound and outbound basis. It is important to note that the size of the fee should not matter, as long as such fees meet the commercial and economic realities of the given transaction. In the final analysis, any fee negotiated should be based on sound economic theory and principles that meet the economic reality of the transaction.
Fortunately, the TCC agreed to uphold the arm's length principle and set the price of the transaction (the Guarantee) between GEC and GEUS, at a price that two independent parties would have agreed to.