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TAX NEWS - may 2010

Canada Tax: Crown clarifies grounds for appeal in GE Capital Canada's guarantee fees case

The Crown, representing the Canada Revenue Agency (CRA), recently filed a Memorandum of Fact and Law with the Federal Court of Appeal (FCA) in support of its 4 January 2010, appeal of the 4 December 2009, Tax Court of Canada (TCC) decision in General Electric Capital Canada Inc. v. The Queen.

The Crown has clarified its position and is seeking either:

- a substantial reduction of the value of the explicit guarantee from the original trial judge's decision of 183 basis points to either nil or to a range of 15 to 24 basis points; or
- a new trial with a new judge.

The TCC judgment appeared to be a conceptual victory for the CRA, because the trial judge considered implicit support when pricing the guarantee fee. The CRA, however, is apparently seeking to convert its conceptual victory into a more tangible success by asking that more significant consideration be given to the implicit support. Thus, the appeal adds further uncertainty in determining guarantee fees in intercompany financing arrangements.

Grounds for appeal

The Crown raises three grounds for appeal:

- Errors of law;
- Errors of fact; and
- Denial of procedural fairness.

Implications for the pricing of guarantee fees

Implicit support

The Crown does not offer any new arguments in the memorandum, and continues to rely on its original position that General Electric Capital Canada Inc. (GECCI) received little to no economic benefit from a formal guarantee because of the widely recognized strength of its parent, General Electric Capital Corporation (GECUS). The Crown considers the parent-subsidiary relationship to be an "economically relevant circumstance" when determining the credit rating from which to start the valuation exercise. In particular, the Crown's position is that, because of the nature of GECCI's affiliation with General Electric, its credit rating is, by default, more or less equalized to that of its parent (the so-called implicit support argument) from the perspective of investors. Thus, the Crown argues, the guarantee is either unnecessary or of nominal value.

In the memorandum, the Crown notes that in determining the value of the guarantee fee, "both parties presented expert evidence on the credit rating that [Standard & Poor's] would have assigned to [GECCI's] debt issuances without explicit guarantees." However, the fact that while both GECCI's and the Crown's experts presented credit ratings that Standard & Poor's would have assigned, they arrived at dramatically different conclusions, is problematic for taxpayers. Indeed, while the memorandum illustrates that the Crown is of the view that implicit support is economically relevant and thus must be considered in determining reasonable guarantee fees, it provides little guidance to taxpayers beyond what was originally offered in the expert witness reports on how to actually measure implicit support, especially in the usual case in which the parent company is not rated AAA.

Measuring implicit support

In the memorandum, the Crown relies on expert witness reports that determined GECCI to be a core subsidiary, the implication of which is that GECUS would provide support in almost all circumstances under which GECCI would otherwise default on its obligations. In such cases, the subsidiary's rating is equal to that of the parent (in this case, AAA). The Crown acknowledges that the FCA may not agree that GECCI is a core subsidiary, and that the implicit support alone would be enough to support a AAA rating. In such circumstances, the Crown suggests a more conservative approach, whereby GECCI is a strategically important subsidiary and would have received a rating of AA+ at a minimum.

Determining a reasonable guarantee fee using bond yields

The Crown argues that if the FCA concludes that GECCI would have received a rating of AA+ in the absence of an explicit guarantee, then a reasonable guarantee fee would be between 0.15 percent and 0.24 percent. This conclusion is reached using both yield spreads between AA+ and AAA bonds and a measure that considers default rates of AA+ bonds as well as the subsequent recovery rates (i.e., the expected loss rate).

Going forward

Until the FCA renders judgment in this case, the TCC's decision stands as the current interpretation of the law as it applies to guarantee fees. If the TCC decision is overturned by the FCA, the new decision will be considered the correct interpretation of the law and will be applied retroactively.

This poses significant challenges for taxpayers while the case progresses through the courts. In the midst of all this uncertainty, one message appears to be quite certain — for the time being, it is advisable to consider the implicit support in the pricing models for guarantee fees. Taxpayers should be vigilant in ensuring that their risk exposure under differing approaches to the calculation of guarantee fees is appropriately managed.

If you are contemplating a guarantee fee structure, or have questions about your existing financing structures, please contact your Deloitte representative for additional guidance.

Further information on the grounds for appeal

The Crown claims that the trial judge committed the following errors:

Errors of law

1. Failed to identify the relevant transaction by introducing a nonexistent or hypothetical fact in considering a case with no explicit parental guarantee, and thus incorrectly identified the transaction under analysis;

2. Failed to consider all economically relevant characteristics by focusing on one expert witness report, which did not consider the low risk of GECCI given GECUS' control, the incentive to GECUS to avoid default, the fact that GECCI and GECUS use the same capital markets, and GECUS' public posture (e.g., its consistent statements of the importance of its AAA credit rating) and record;

3. Failed to perform a reasonableness check to corroborate his conclusions; and

4. Misapplied the "business judgment rule" by using subjective evidence of the GECUS executive who instituted the guarantee fee in a "tax-driven context" and, thereby misinterpreting the purpose of the Canadian transfer pricing regime and the OECD guidelines.

Errors of fact

1. Rejected expert testimony for inappropriate reasons, including the assumption that a stand-alone credit rating is a necessary first step in a guarantee fee analysis;

2. Erroneously preferred an expert's testimony that was uncorroborated and contradicted by GECCI's other witnesses;

3. Erred in concluding GECCI could not get back-up credit facilities, which was "contradicted by all the evidence"; and

4. Committed other errors in understanding the evidence and used improper and unjustifiable reasons to discredit the conclusions of three of the Crown's witnesses.

Judicial conduct

1. Unfairness during the trial process due to the trial judge's introduction of theories, eliciting of improper evidence, and excessive intervention; and

2. Gave inadequate reasons for judgment in that the reasons for judgment treat evidence inconsistently, ignore significant evidence, and fail to provide adequate analysis on pivotal issues.
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