Crown's Appeal Dismissed In General Electric Case

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...

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