Release date: January, 12, 2010
Guest: Jeff Rogers
Running time: 11:42 minutes
Has the GE Capital case redefined the arm's length principle? Listen to Jeff Rogers, a PwC Transfer Pricing senior manager, to find out.
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You're listening to another episode of PwC's Tax Tracks at www.pwc.com/ca/taxtracks. This series looks at the most pressing technical and management issues affecting today's busiest tax directors.
Gerry Lewandowski: Here with us today is Jeff Rogers, a senior member of PwC Canada's Transfer Pricing group based in Toronto and a specialist in intercompany financing transactions. In the International Tax Review’s 2010 World Tax Rankings, Jeff was recognized for his work in transfer pricing.
Jeff has been with PwC Canada for eight years and provides transfer pricing services to Canadian-based and foreign-based companies engaged in cross-border financing transactions. Jeff will share with us some of his insights on the General Electric Capital Canada Inc. case, which was decided by the Tax Court of Canada on December 4, 2009.
Thanks for joining us, Jeff.
Jeff: Thank you. I am happy to be here.
Gerry: So Jeff, the GE Capital Case dealt with the payment of guarantee fees between related parties. Can you give us a short summary of the facts and findings of the case?
Jeff: Sure. As a quick background, during its 1996-2000 taxation years, GE Capital Canada deducted guarantee fees of $136 million for financial guarantees that were provided by GE Capital US, the parent company. The guarantee fee charged was one per cent of the $13.6 billion dollars in the debt that was issued with the guarantee.
The Minister of National Revenue reassessed to disallow the deduction of all guarantee fees paid to GE Capital US over the period on the basis that the guarantees fees paid were not arm’s length.
The Minister submitted that the arm’s-length price of the guarantee between GE Capital US and GE Capital Canada was zero on the basis that, in the absence of this guarantee arrangement, GE Canada Capital’s credit rating would be equalized with that of GE Capital US solely by reason of affiliation. The Minister claimed that GE Capital Canada could have borrowed the same amount of money at the same interest rate without an explicit guarantee as it did with such a guarantee. As a result, GE Capital Canada did not receive an economic benefit from the guarantee.
GE Capital Canada submitted that a benefit was provided as a result of this guarantee as it could borrow large amounts of capital at interest rates enjoyed by its parent company, GE Capital US.
To measure this credit enhancement, GE Capital Canada claimed that its credit rating must be estimated prior to the implementation of this explicit guarantee and should be determined solely on a stand-alone basis without factoring in any implicit support from GE Capital US. GE Capital Canada presented evidence during the trial that its stand-alone credit rating was, at most, BB, during the years in question and the economic benefit by GE Capital Canada under this guarantee fee arrangement far exceeded the fee that was actually paid to GE Capital US.
After considering the evidence, the Tax Court of Canada decided that there was an economic benefit conferred by the explicit guarantee that was provided by GE Capital US, and under the circumstances, the one-per cent guarantee fee that was actually paid was viewed to be equal to or below an arm’s-length price. The Court allowed GE Capital Canada’s appeals and ordered that all of the Minister’s reassessments related to the payment of guarantee fees over the period be vacated.
Gerry: So Jeff, how did the Tax Court of Canada apply the arm’s length principle in evaluating the guarantee?
Jeff: Well, let’s remember that the fundamental principle of transfer pricing is the arm’s length principle. When the arm’s length principle is typically applied, it severs the relationship between related parties in a multinational enterprise. The entities are to be treated as independent enterprises and their relations with each other should be consistent with those that would be observed in the free market between other independent enterprises.
In its interpretation of the arm’s length principle, the Court did not impose a strict separation of GE Capital Canada and GE Capital US but rather, the Court recognized and considered all of the – and I quote – "the economically relevant characteristics of the transaction that may influence the arm’s length price in their negotiations." The Court refers to the OECD who recognizes that transfers between related parties do not necessarily reflect free market forces and are entered for the multinational enterprise on the whole. The Court essentially recognizes and embraces the parent-subsidiary relationship as an economically relevant characteristic and that imposes arm’s length negotiations between the two non-arm’s length parties.
In doing so, the Court recognized that both GE Capital US and the overall parent company GE advertised the materiality of the AAA credit rating to their operations. The failure of GE or GE Capital US to meet its subsidiaries' financial obligations would obviously taint its reputation because AAA-rated issuers, which they were rated, are not expected to allow their subsidiaries to default. The reputational pressures exerted by GE Capital US' debt holders would force them to act during periods of financial distress.
Subsequently, the Court evaluated the guarantee transaction that was in place between GE Capital Canada and GE Capital US and considered the overall economics of that transaction, including the overall business environment, to ensure that we could have reliable comparisons to uncontrolled transactions. The guarantee fee was established in the context of the parent-subsidiary relationship where implicit support is a relevant economic characteristic, but it should not be included in the quantification of the benefit from which the fee is derived.
Gerry: Now what did the Tax Court of Canada have to say on the concept of an implicit guarantee or implicit support? How is this different from an explicit guarantee?
Jeff: An explicit guarantee is a legally binding obligation that the guarantor will support the debt obligation of the entity receiving the guarantee. It is recognized as a contingent liability to the guarantor. In contrast, an implicit guarantee is not legally binding; it is implied. At its most extreme, if a third-party lender advances funds to a subsidiary and that subsidiary defaulted on its obligations, the third-party lender would not have recourse to the parent company.
The Court in this case recognizes implicit support as the reputational risk that would encourage GE or GE Capital US to meet those financial obligations, but also recognized that implicit support is of limited value, stating “it is something investors believe exists and may be available to provide financial support if the right circumstances are present, but few investors are foolish enough to believe it is equivalent to an explicit guarantee.”
There are recent developments in the financial markets today – in particular in Dubai – where the government rejected any implicit guarantee of Dubai World debt and that may have reinforced the Court’s decision to place limited value on implicit support.
Ultimately, the evidence that was presented during the trial overwhelmingly indicated that GE Capital Canada would not have been able to borrow either the quantum of debt it was able to – at the interest rates it paid – without that explicit guarantee.
Gerry: Jeff, the Tax Court of Canada examined certain kinds of evidence, including business judgment. How did the Court evaluate the testimony of witnesses?
Jeff: The Court definitely found the testimony of the retired treasurer of GE Capital US, Mr. Jeffrey Werner, the most compelling. Mr. Werner explained that the guarantee was executed in 1989, but there were no guarantee fees charged until 1996, and this guarantee was implemented solely for business purposes.
Some of the business reasons that the Court heard was that:
Mr. Werner’s credibility was also supported as by other witnesses as:
The Court also preferred the testimony that had more quantitative support.
For an example, you are an employee of a US company and are sent to work for a Canadian subsidiary. Your compensation costs are charged to the Canadian subsidiary. Under the old rules, you may have been able to claim a Treaty exemption from Canadian tax since the Canadian subsidiary arguably was not the "employer" under common law principles. It was the US company that was your employer. Under the new rules, the Treaty exemption is no longer available to you because the Canadian subsidiary paying you does not have to be an employer, but only a Canadian resident person under the Treaty.
Gerry: So Jeff, to summarize all of this, what are you recommending that tax directors should be taking from this GE case?
Jeff: Well, the Court ultimately applied a three-notch increase to GE Capital Canada’s stand-alone credit rating, recognizing those reputational pressures and economic incentives that would entice GE Capital US to provide support to maintain its own AAA credit rating. This decision by the Court should not be viewed as prescriptive.
The Court was very careful to point out, and I quote, “one must be aware that it would be dangerous for taxpayers to draw general inferences from this particular case, as differences in facts or circumstances or in the economically relevant characteristics of a transaction can lead to a very different result. In the final analysis, transfer pricing is largely a question of facts and circumstances coupled with a high dose of common sense.”
Given the Court’s conclusion, I recommend that tax directors focus on the facts and circumstances and common sense that would be applicable to their own transaction.
In establishing a guarantee fee, I recommend that the taxpayers focus on the guarantee that was provided and what is the benefit that was conferred to the receiving party given the economically relevant circumstances to all the parties that were involved in the transaction.
Gerry: Thank you, Jeff, for your insight into this important case.
For further information on this, please contact your local PwC professional or go to our PwC transfer pricing website at www.pwc.com/ca/transferpricing.
Thank you for tuning into Tax Tracks at www.pwc.com/ca/taxtracks.
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Through interviews with prominent PwC tax subject matter professionals, Tax Tracks is an audio podcast series that is designed to bring succinct commentary on tax technical, policy and administrative issues that provides busy tax directors information they require.