Current Cases: General Electric Case: Deductibility of Guarantee Fees

March 2010 | David W. Chodikoff

On December 4, 2009, Justice Hogan of the Tax Court of Canada issued his Reasons for Judgment in the case of General Electric Capital Canada Inc. (“GECC”) v. The Queen (2009 TCC 563).  GECC, a Canadian corporation, operated a financial services business.  GECC borrowed funds from the capital markets and then used these borrowed monies to lend to or to enter into leasing transactions with other parties on profitable terms.  GECC was an indirect wholly-owned subsidiary of General Electric Capital Corporation (“GECUS”), a U.S. company.  GECUS charged GECC a fee for guaranteeing the debts of GECC owing to third party creditors.  The guarantee fee was equal to 1% per annum of the principal amount of the outstanding debt securities.  In respect of the 1996 to 2000 taxation years, GECC deducted the guarantee fees paid to GECUS in computing its income.

The Minister of National Revenue (the “Minister”) reassessed GECC’s tax returns for the taxation years under review and denied the deduction of the guarantee fees, deeming the “arm’s length” price to be zero since the guarantee fees were not necessary and GECC derived no economic benefit from them.  The Minister disallowed approximately $136 million of guarantee fees deducted by GECC.

The Tax Court found that GECUS had “de jure” control over GECC and therefore, GECC and GECUS were related and not dealing at arm’s length.  The critical question for Justice Hogan was whether the arm’s length price for the guarantee was at least 100 basis points as argued by GECC or zero as asserted by the Minister.

GECC argued that its affiliation to GECUS and any benefit arising therefrom could not be considered under subsection 69(2) and paragraph 247(2)(a) of the ITA.  GECC also argued that these provisions require the Court to consider how GECC and GECUS would conduct themselves if, in fact, they would have arranged their transaction on the basis that they were dealing at arm’s length.  In so doing, GECC argued that its credit rating would at the very best be a BB.

Justice Hogan stated that “In the final analysis, the arm’s length principle in the transfer pricing context is tied to modern economic theory, which is based on observations of how parties act in the marketplace”.  According to Justice Hogan, “the question becomes one of fact or, more precisely, one of identifying the economically relevant characteristics of the transaction that may influence the arm’s length parties in their negotiations”.

The Court further considered the OECD guidelines and concluded that these guidelines are “a clear articulation of the importance of maintaining the relevant economic characteristics of the controlled transaction in order to ensure the reliability of the comparisons with uncontrolled transactions”.   The Court thus considered the impact of implicit support.  Hogan, J. reasoned that a third party guarantor would not control the financial function of its debt in the way that GECUS exerted its control over GECC’s default risk.  Therefore, the Court stated that “a third party guarantor would assume more risk than GECUS in the instant case”.

The Court still had to determine whether the guarantee provided by GECUS had any additional economic benefit.  This required the Court to determine on a factual basis GECC’s credit rating without the explicit support of GECUS.  The Court reviewed numerous factors including testimony from 12 expert witnesses.  The Court accepted expert evidence that a reasonable price for the guarantee fee could not exceed the benefit GECC received.  It concluded that GECC’s credit rating without the express support of the guarantee from GECUS would be in the range of BBB-/BB+.  In quantifying the benefit that GECC received, Justice Hogan accepted GECC’s position that the interest cost savings was approximately 1.83%.  Therefore, the Court concluded that the 1% guarantee fee was equal to or below an arm’s length price.  The difference between the guarantee fee of 1% and the interest cost savings of approximately 1.83% represent GECC’s economic incentive to enter into the transaction with GECUS.  Therefore, GECC received a significant economic benefit from the transaction.

Not surprisingly, on January 4, 2010, the Crown filed an appeal.  The basis for the appeal includes the assertion that the Crown was denied its rights to natural justice and procedural fairness insofar as the trial judge had intervened excessively in the questioning of witnesses; he failed to apply the rules of evidence and did not provide evidentiary rulings all of which now leads the Crown to assert that there is a reasonable apprehension of bias.  The Crown is known to plead “the Kitchen Sink” when it is seeking to overturn an unwanted lower court decision.  The forthcoming hearing which will likely occur later in 2010 should make for interesting times in the Federal Court of Appeal.  The appeal of this decision also means that uncertainty remains regarding the transfer pricing of financial transactions.  Now more than ever, taxpayers need to analyze their potential exposure under different transfer pricing models and determine what is the most supportable position in light of their particular set of facts.

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