TAX NEWS - DECEMber 2009

GE Capital Canada prevails in guarantee fee case

The Tax Court of Canada on December 4 issued a long-awaited decision in the case General Electric Capital Canada Inc. vs. The Queen. The court held in favor of GE Capital Canada Inc., allowing it to maintain as a deductible expense 100 percent of the guarantee fee paid to its U.S. parent, General Electric Capital Corporation (GECUS) during the 1996-2000 period. In his decision, Justice Robert Hogan ruled that the 100 basis points (1 percent) guarantee fee was an arm's length price.

The case stems from a guarantee fee arrangement between a Canadian subsidiary and its U.S. parent. GECUS unconditionally guaranteed all payments due under all debt securities issued after 1988 by its wholly owned subsidiary, General Electric Capital Canada Inc. In 1995, GECUS began to charge a 1 percent per annum fee for those financial guarantees. The CRA issued reassessments totaling $136 million for taxation years ended 1996 to 2000, denying the deductions for guarantee fees claimed by GE Capital Canada in those years. In April 2006, GE Capital Canada filed a notice of appeal regarding the CRA's denial of the deductions.

The decision has far-reaching implications for the pricing of guarantee fees in Canada. The method the court used to arrive at its conclusion provides a framework for pricing guarantee fees that is a complex, multistep approach requiring many inputs. These are summarized below.

- Determine the recipient's stand-alone creditworthiness – The court's approach starts by ascertaining the creditworthiness of the guarantee recipient. Distinctions were made between a "status quo" rating, taking into account the benefits of the common name, the parent's management team and existing business arrangements, such as intercompany loans, and a stand-alone rating, which abstracts from such benefits. The judge favorably cited the status quo rating of BB-/B+ developed by an expert testifying on behalf of GE Capital Canada.

- Adjust to the final rating incorporating implicit support – The court then considered any enhancements to the initial rating from implicit support. The judge noted that GE and GECUS had a widely advertised AAA credit rating that they would seek to protect, and, as such, would be economically motivated to provide support to GE Capital Canada even in the absence of a formal guarantee. In assigning a three-notch uplift to GE Capital Canada's initial rating, the judge rejected the notion that the implicit support would result in an equalization of the rating of GE Capital Canada to AAA. Justice Hogan similarly rejected an approach that would start with the parent's credit rating and then notch down.

- Price the upper bound using the yield approach – The judge favorably cited testimony from Jeffrey Werner, retired Treasurer for GECUS and GE Capital Canada during the years of the disputed guarantee fee, that the guarantee fee had been priced based on the benefit to the guarantee recipient, and that GE Capital Canada would not pay more for the guarantee fee than the benefit of the fee. Judge Hogan goes on to equate the benefit with the interest cost savings, although noting based on expert testimony that additional cost savings were likely to have been realized, such as on placement fees and a backup credit facility. The judge did not comment on testimony that the benefit included substantially greater borrowing capacity for GE Capital Canada. Accepting calculations by an expert for GE Capital Canada, the judge determined an upper bound of 183 basis points for the guarantee fee.

- Finalize the arm's length range of guarantee fee – The judge, noting that GE Capital Canada cannot be expected to pay 100 percent of its interest cost savings, ruled that 100bps "is equal to or below an arm's length price. "Judge Hogan would reach his decision on the 100 bps fee without suggesting how to fix the arm's length range of guarantee fees.

For the Canadian market, certainly, the decision confirms that guarantee transactions have a more-than-nominal value. Rejecting various arguments presented by the Crown, the judge affirmed that such transactions need to be priced in accordance with the arm's length principle. However, the decision also introduces uncertainty with regard to the application of the arm's length principle because of complications attendant to factoring implicit support into the analysis. Put in the context of the OECD Guidelines, the decision increases uncertainty with regard to the interpretation of Paragraph 7.13, which deals with issues surrounding passive association.

The decision directs taxpayers to the stand-alone rating of the recipient as the starting point. The conversion of the standalone rating to the status quo rating is likely to be problematic for practitioners, given the lack of guidance in the decision. As to the next step in the analysis, the establishment of the final rating, the judge emphasized that implicit support is strictly a matter of facts and circumstances. The judge cited public rating agency requirements for more concrete signs of implicit support to bridge a ratings gap between the recipient and its parent; that is, simply assuming parental support absent those concrete signs flies in the face of the legal separation of corporations. "The extent of a shareholder's exposure through the corporation is limited to the amount of capital the shareholder chooses to invest. In the absence of a guarantee from the shareholder, creditors can expect nothing more nor less."

Judge Hogan cited expert testimony that the upgrade for implicit support is not greater than two or three notches. Thus, the value of implicit support can be perceived as relatively modest (given the 12-13 notch ratings gap between the initial rating of GE Capital Canada and GECUS).

The case will have repercussions in the Australian market as well, as the Australian Taxation Office (ATO) has been targeting "excessive" guarantee fees in its audit program. In 2008, the ATO issued a discussion paper that stated that the stand-alone credit rating is the appropriate starting point; however, in its view, lenders may notch upwards from 1 to 9 notches having regard to implicit credit support provided by the parent. Although Judge Hogan allowed for upward notching, the rationale for limitation in this case to just two or three notches will likely be considered closely by both the ATO and multinationals with guarantee arrangements in Australia. The ATO is expected to publish further rulings and papers on debt financing issues over the coming months.

The Crown has 30 days from the date of release of the opinion to appeal.