Judgment summary
This is an appeal by Her Majesty the Queen from a decision of Hogan J. of the Tax Court of Canada, which vacated assessments issued against General Electric Capital Canada Inc. under Parts I and XIII of the Income Tax Act for the 1996 to 2000 taxation years (para. 1).
The Part I assessments denied deductions claimed for guarantee fees paid to General Electric Capital US (GECUS), the respondent's parent company, for guaranteeing its capital market borrowings, on the basis that an arm's length party would not have paid such fees (para. 2). The Part XIII assessments reflected consequential adjustments treating the fees as deemed dividends (para. 2).
The case concerned the application of the now repealed subsection 69(2) and paragraphs 247(2)(a) and (c) of the Income Tax Act, which allow the Minister to make transfer pricing adjustments where a taxpayer pays a non-arm's length non-resident more than an arm's length amount (para. 3).
The Tax Court Judge found as fact that the guarantee fees paid did not exceed an arm's length amount and vacated the assessments (para. 4). The Crown appealed, alleging errors of law, palpable and overriding errors of fact, and a reasonable apprehension of bias (para. 5).
The Federal Court of Appeal, per Noël J.A., dismissed the appeal with costs (para. 93).
Background
During the years in issue, the respondent was wholly owned by GECUS, a United States corporation, itself wholly owned by General Electric Company (GE), also a United States corporation (para. 7). The respondent financed a substantial portion of its operations through debt in the form of commercial paper and unsecured debentures (para. 7).
Between 1988 and 1995, GECUS provided an explicit guarantee for the respondent's debt issuances at no cost. Starting with the 1996 taxation year, GECUS began charging a fee equal to 1% of the face amount of the respondent's debt issuances for that guarantee (para. 8).
Fees totalling $135.4 million were paid and deducted by the respondent in computing its income under Part I for its 1996 through 2000 taxation years (para. 9). The respondent also withheld and remitted non-resident tax at 10% of the fee under Part XIII, being the reduced rate under article XI of the Canada-United States Income Tax Convention (para. 9).
The Minister disallowed the deduction, assessing under subsection 69(2) for the 1996 and 1997 taxation years and under paragraphs 247(2)(a) and (c) for later years (paras. 10-11). The Minister's guiding assumption was that GECUS would have supported the respondent regardless of the guarantee, making it superfluous (para. 13). Consequential Part XIII assessments treated the fee as a deemed dividend subject to withholding tax at 5% under article X of the Convention (para. 14).
The respondent objected, and after the assessments were confirmed, appealed to the Tax Court of Canada (paras. 15-16).
Core dispute
The Crown's theory was that the respondent's credit rating would be equalized with that of GECUS by reason of affiliation (implicit support), so that the respondent could have borrowed at the same rate without an explicit guarantee, meaning the guarantee provided no economic benefit and an arm's length price for it would be nil (para. 17).
The respondent argued that the concept of implicit support relied on by the Crown required preserving the very non-arm's length relationship that subsection 69(2) and paragraph 247(2)(a) required to be ignored, and that all factors of influence flowing from the non-arm's length relationship must be disregarded to ensure an arm's length result (para. 20).
On appeal, the Crown alleged four errors of law: failing to properly identify the relevant transaction by taking into account the notional removal of the guarantee; erring in preferring the evidence of the respondent's expert without regard to four significant valuation characteristics; failing to conduct a reasonableness check; and improperly relying on the business judgment of a former GECUS executive (paras. 32-35). The Crown also alleged palpable and overriding errors of fact and a reasonable apprehension of bias arising from the Tax Court Judge's conduct at trial (paras. 36-38).
The respondent contended that no such errors were made and that, in any event, the Tax Court Judge had committed two further errors favourable to the Crown, being consideration of implicit support at all and adoption of the yield approach rather than a market price approach, which if corrected would still result in dismissal of the appeal (paras. 43-45).
Court findings
The Federal Court of Appeal held that the concept underlying subsection 69(2) and paragraphs 247(2)(a) and (c) requires ascertaining the price that would have been paid if the parties had dealt at arm's length, taking into account all circumstances bearing on the price, whether arising from the relationship or otherwise (para. 54). Implicit support was therefore a relevant factor which had to be considered (paras. 53, 56), consistent with the OECD Transfer Pricing Guidelines (para. 57) and the Court's decision in Glaxosmithkline Inc. v. Canada, 2010 FCA 201 (paras. 58-59).
The Court found that the Tax Court Judge erred in considering the impact of the notional removal of the guarantee having actually occurred, rather than confining this to the valuation exercise (paras. 63-66). However, this error did not affect the outcome, since the finding of a credit rating gap rested primarily on the evidence of Dr. Chambers, for whom the impact of removal was a minor consideration among twelve factors (paras. 67-74).
The Court rejected the Crown's remaining alleged errors of law, finding no basis to conclude the Tax Court Judge ignored relevant valuation characteristics (para. 76), that no reasonableness check was in fact purported to be conducted (paras. 77-79), and that reliance on the business judgment of Mr. Werner was only considered after an objective finding that the guarantee was necessary (paras. 81-82).
On palpable and overriding error, the Court found the evidence supported the Tax Court Judge's preference for Dr. Chambers' evidence and his finding regarding the unavailability of back-up lines of credit without the explicit guarantee (paras. 83-87). Quotes from the Royal Bank of Canada and the Bank of Nova Scotia, though exploratory, corroborated a lower credit rating without explicit support (paras. 70-71, 86-87).
On procedural fairness, the Court distinguished Heron Bay Investments Ltd. v. Canada, 2010 FCA 203, finding that the Tax Court Judge did not introduce his own theory of the case (as this had come from Dr. Chambers' report) and that his finding on the impact of removal did not play a critical role in the outcome, although his questioning on this issue was excessive and made counsel uncomfortable (paras. 90-91). This did not establish a reasonable apprehension of bias (para. 91). The reasons for judgment were found sufficient to permit meaningful appellate review (para. 92).
Outcome
The Federal Court of Appeal dismissed the appeal with costs (para. 93).
Tp method highlighted
The Tax Court Judge adopted the yield approach to determine the arm's length price of the guarantee, measuring the benefit as the interest cost savings resulting from comparing the interest cost of unguaranteed debt to that of guaranteed debt, requiring a factual finding of the respondent's credit rating without explicit parental support (paras. 25, 259).
The insurance-based model proposed by one party was rejected as unreliable, as it tended to price the guarantee too high and used a credit rating product (RiskCale) that did not account for implied support (paras. 23, 254, 256). The credit swap method proposed by the respondent was also rejected because it relied on an assumed credit rating provided by counsel rather than an independently derived figure (para. 24, 258).
Using the yield approach, the Tax Court Judge preferred the evidence of Dr. Chambers over that of Mr. Emmer, finding the respondent's credit rating without the explicit guarantee would have been in the range of BB+ to BBB-, compared with the AAA rating achieved with the guarantee (paras. 27-28). The resulting interest cost savings under the yield approach worked out to approximately 183 basis points (1.83%), and the Tax Court Judge concluded that a 1% guarantee fee was equal to or below an arm's length price, since the respondent received a net economic benefit exceeding the 1.83% figure (para. 29).
Major issues / areas of contention
- Whether implicit support arising from a non-arm's length relationship can be considered in determining the arm's length price under subsection 69(2) and paragraphs 247(2)(a) and (c) of the Income Tax Act.
- Whether the Tax Court Judge erred in identifying the relevant transaction by taking into account the notional removal of the explicit guarantee.
- Whether the Tax Court Judge erred in preferring the evidence of the respondent's expert (Dr. Chambers) over the Crown's experts.
- Whether the Tax Court Judge was required to conduct a reasonableness check on the pricing methodology.
- Whether reliance on the business judgment of a former GECUS executive was a legal error given the requirement for objective evidence under the arm's length principle.
- Whether the Tax Court Judge made a palpable and overriding error in finding the respondent could not have obtained back-up lines of credit without the explicit guarantee.
- Whether the Tax Court Judge's conduct of the trial, including his questioning of witnesses, gave rise to a reasonable apprehension of bias.
- Whether the reasons for judgment were adequate to permit meaningful appellate review.
- The correct methodology (yield approach versus insurance-based model versus credit swap method versus market price approach) for determining the arm's length price of a guarantee fee.