Canada Tax Court ruling on arm s length arrangement for explicit guarantee provided by a parent to its subsidiary

Transcription

1 Tax & Regulatory Services News Alert* 12 March, 2010 Canada Tax Court ruling on arm s length arrangement for explicit guarantee provided by a parent to its subsidiary Background On 4 December, 2009, the Tax Court of Canada ( TCC ) released the long awaited decision in the case of General Electric Capital Canada Inc. 1 (GE Canada or taxpayer). The issue under dispute was whether the parent company, i.e. GE Capital Corporation Inc. ( GE US ) had charged GE Canada, an arm s length guarantee fee for the tax years The matter was eventually ruled by the TCC in the taxpayer s favour. Facts GE Canada operated as a wholly owned financial services subsidiary of GE US, engaged in a variety of businesses related to equipment leasing and financing. To fund its business operations, GE Canada relied significantly on funds borrowed through issuance of commercial paper and unsecured debentures, exclusively to third parties or GE US. These financing activities of GE Canada were handled by GE US s treasury department. GE US had provided an explicit guarantee on the borrowings of GE Canada since However, it began charging a fee for the explicit guarantee only in 1995, equal to 1% of the principal amount of debt securities outstanding per annum. GE Canada claimed deduction for the guarantee fees that became payable to GE US for the tax years 1996 to Genral Electric Capital Canada Inc. v. Her Majesty the Queen [2009] TCC 563 *connectedthinking pwc

2 The deductions claimed by GE Canada were disallowed by Canada s Revenue Agency ( CRA ), which argued that the guarantee fees should be zero due to the implicit guarantee inherent in the parent-subsidiary relationship between GE US and GE Canada. CRA argued that GE Canada could have raised the debt without the benefit of the explicit guarantee, because of the implicit support available from GE US. In CRA s opinion, since the guarantee fees paid were a gratuitous distribution of value, it sought additional withholding tax from GE Canada on the basis that the fees paid should be deemed as dividends. The matter was appealed by GE Canada before the TCC. Proceedings before the TCC The CRA extended several arguments before the TCC to justify its reasoning that the arm s length price of the explicit guarantee provided by GE US to GE Canada should be Nil. The key arguments extended by the CRA are as follows: The CRA placed heavy reliance on the guidance given in Paragraph 7.13 of the OECD Guidelines 2 which provides that no intra-group service would be said to have been received where an associated enterprise, by reason of its affiliation alone, has a credit rating higher than it would have had, if it were unaffiliated. However, an intra-group service would usually exist where the higher credit rating was due to a guarantee by another group member. The CRA argued that GE Canada s credit rating would have been the same as GE US s credit rating (GE US was assigned an issuer rating of AAA by both S&P and Moody s) even if there had been no explicit guarantee by GE US, simply by virtue of its affiliation with GE US. The explicit guarantee was therefore, merely an affirmation of the implicit support that already existed between GE Canada and GE US. The CRA argued that the relationship between GE Canada and GE US was an economically relevant circumstance that could not be ignored while evaluating the arm s length nature of the structure and price of the controlled transaction. This 2 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations by the Organization for Economic Co-operation and Development meant that GE US would have unconditionally supported GE Canada s borrowings and ensured that GE Canada did not default even in the absence of an explicit guarantee, because of the relationship between them. GE US had a strong economic incentive to not let GE Canada default on its payments because of the potential damage to GE US s credit rating from such default and other underlying factors such as GE Canada bearing the GE name, and GE Canada being a strategically important or core subsidiary. The CRA argued that the additional borrowing costs for GE US (in the event of a default by GE Canada and a deterioration in the credit rating of GE US) would have exceeded the cost of financial support to GE Canada and therefore GE US would not have let GE Canada default even in the absence of an explicit guarantee. The CRA contended that a stand-alone credit worthiness analysis of GE Canada was meaningless since GE US, being a parent, controlled GE Canada s capital structure, and therefore could manipulate its credit rating as it wanted. Thus, the CRA reasoned that GE Canada s credit rating would have equalised with the credit rating of GE US even in the absence of an explicit guarantee arrangement. Since GE Canada did not receive any additional economic benefit from the explicit guarantee arrangement, the arm's length price for the guarantee should have been Nil. The taxpayer also made several arguments before the TCC to justify the arm s length nature of the explicit guarantee fee arrangement with its parent. The key arguments extended by the taxpayer are as follows: The taxpayer argued that it paid an arm's length price for the explicit guarantee to GE US. It presented several analytical approaches in support of the quantum of the guarantee fee, which essentially revolved around its view of how to apply the arm s length principle. Essentially, the taxpayer opined that the impact of share ownership / relationship between GE US and itself and the benefits derived by both the parties as a result (for example the benefit of implicit support to the taxpayer, and the benefit of higher dividends as a result of greater profits arising from the guarantee to GE US) were to be disregarded for the purpose of analysing if the parties were dealing at arm s length.

3 The taxpayer argued that an implicit guarantee was not a substitute for an explicit guarantee and that investors in its debt securities would not be willing to lend to it on the same terms in the absence of an explicit guarantee. The taxpayer argued that its credit rating would have been much lower had only implicit support been taken into account in the analysis, without any explicit guarantee. The taxpayer further contended that in the absence of an explicit guarantee, it would not have been able to obtain the required standby credit facilities of GE US. TCC Ruling Based on the facts and circumstances of the case, the key arguments extended by the CRA and the taxpayer, and the expert testimonies provided by 20 witnesses (12 of whom were specialists), the TCC ruled as follows: What is meant by Arm s Length? The TCC ruled that the question of how to define the term arm s length assumed central importance in the case. The TCC undertook a detailed analysis of the definition of the term arm s length, and the concepts of de jure control 3 and de facto control. The TCC eventually ruled that the specific facts of the case and economically relevant characteristics of the controlled transaction need to be evaluated carefully from the perspective of comparability and arm s length price determination. What is the relevance of share ownership between parties? The TCC stated that on one hand, the taxpayer argued that the relationship between the parties should be ignored completely so as to put the parties on the same basis as two independent parties. On the other hand, the CRA argued that share ownership is an economically relevant circumstance and must be a factor in determining the appropriate compensation for a controlled transaction. Addressing these divergent views, the TCC acknowledged that share ownership did have an impact on how investors viewed the taxpayer s credit rating even in the absence of an explicit guarantee. TCC opined that a default by the taxpayer would lead GE US to step in and support the taxpayer even in the absence of an explicit guarantee because of the share ownership and reputational risk involved. This reputational risk would not exist between third parties. Therefore, at arm s length, an explicit guarantee would necessarily be required before another party would assume such a risk. The TCC also differed from the CRA s position that GE US controlled the capital structure of the taxpayer and therefore, could choose the amount of equity invested and control the taxpayer s debt to equity ratio. The TCC stated that this contradicts the well-accepted principle that a corporation is a separate person whose existence provides limited liability protection to its shareholders such that the extent of a shareholder s exposure is limited to the amount of capital the shareholder chooses to invest. What is the difference between Implicit vs. Explicit Guarantee Support? The TCC recognized the difference between implicit support, which does not provide for a guaranteed recourse, and an explicit guarantee which provides much stronger protection and a legally enforceable recourse to the lender. The TCC rejected CRA s position by acknowledging that investors did not view implicit support and an explicit guarantee as equivalent and that it would be wrong to conclude that the taxpayer s credit rating would be the same as that of GE US if there were no explicit guarantee in place. What is the appropriate methodology to determine the Arm s Length Price? The TCC considered various methodologies for analyzing the controlled transaction and concluded that a Yield approach 4 could be considered appropriate to arrive at its arm s length price. 3 Control due to share ownership 4 Comparing the unguaranteed and guaranteed credit ratings of GE Canada and thus arriving at the value of the benefits resulting to GE Canada from the guarantee provided.

4 GE US carried out an analysis using this approach and determined that the benefit of the explicit guarantee provided to the taxpayer was between 1% and 3% while GE US actually charged the taxpayer, a guarantee fee of only 1%. The TCC did not agree with the above working of the benefit. The TCC independently evaluated the taxpayer s stand-alone credit rating range without the guarantee and without the implicit support from GE US as B+ to BB-. After factoring into account, the implicit support from GE US, the taxpayer s rating range without the explicit guarantee worked out to BBB-/BB+. Thus, the TCC notched up the taxpayer s credit rating based on its relationship with GE US, acknowledging that share ownership did impact how investors viewed the taxpayer s credit rating even in the absence of an explicit guarantee. However, the TCC clarified that this notching up could not close the entire credit rating gap between the taxpayer and GE US. Thus, instead of a benefit of 1% to 3%, as computed by GE US, the TCC worked out a benefit of 1.83% 5 that accrued to the taxpayer, as a result of the explicit guarantee support. Thus, the TCC concluded by stating that a 1% guarantee fee was equal to or below the arm's length price and was allowable, therefore not attracting any additional dividend withholding tax. The TCC also stated that the taxpayer actually received a significant net economic benefit from the transaction of even more than the 1.83%, as it could not itself have procured the standby facilities required to support its debt programme and did not reimburse GE US for the latter's costs on its standby arrangements. Conclusion The decision of the TCC has important ramifications in terms of transfer pricing issues relating to inter-company loans and advances. Related party guarantee arrangements have always been a matter of contention between the taxpayer and the tax administration given the difficulty in clearly identifying the implicit and explicit financial support to a subsidiary. This decision places greater importance to the explicit relationship that exists between the guarantor and the guarantee, while determining whether payment of guarantee fees is at arm s length. The decision also highlights the importance of using sophisticated benchmarking methods and credit rating analysis to price inter-company guarantees and loans in an arm's length manner. The Indian revenue authorities are expected to focus on such transactions between the Indian taxpayer and the overseas group entities closely now. Until now, it was only the interest rate that was evaluated from an arm s length perspective in an intercompany loan transaction. However going forward, it is expected that not just interest rates, but various other aspects such as business circumstances surrounding the loan, inter-company guarantee arrangements, debt-equity mix of the borrower, etc. are going to be closely examined. The TCC s decision also has interesting linkages with the recent rulings of the Indian Income Tax Appellate Tribunal (Tribunal) in the case of Perot Systems TSI (India) Ltd. 6 and VVF Ltd. 7 (taxpayers). In both cases, the grant of interest free foreign currency loans by the taxpayers to their overseas group entities was held by the Indian Transfer Pricing Officer (TPO) to be not in accordance with the arm s length regulations and accordingly an upward adjustment to the taxable income of the taxpayers was made. The order of the TPO was upheld by the Commissioner Appeals as well as the Tribunal in both cases. The Tribunal s viewpoint in both cases was that interest free loans given to overseas group entities may not be viewed as arm s length from an India transfer pricing perspective unless the character and substance of the transaction were brought out clearly vide underlying documentation along with a sound business case and arm s length test analysis. Further, particularly in the case of VVF Ltd., the Tribunal opined that the credit rating of VVF equated with the credit ratings of its subsidiaries, while arriving at the arm s length price of the loan extended by VVF Ltd. to its subsidiaries. The Tribunal did not give any specific reasons for opining thus. 5 Essentially, interest cost savings achieved by the taxpayer in lieu of the higher credit rating achieved due to the explicit guarantee from the parent. 6 7 Perot Systems TSI (India) Ltd. v. DCIT [2010-TIOL-51-ITAT-DEL] VVF Ltd. v. DCIT [2010-TIOL-55-ITAT-MUM]

5 The stance of the Tribunal of equating the credit rating of a parent with that of its subsidiary is in stark contrast with the GE Canada ruling, where the TCC, through detailed analysis and several expert testimonies, established that a higher credit rating of the parent company does not automatically translate into a similar credit rating for its subsidiary. Since the TCC has based its judgment on extensive and detailed analyses, it appears to provide a better viewpoint on transfer pricing for intercompany loan and guarantee arrangements. For private circulation only Contact Ahmedabad President Plaza, 1st Floor Plot No 36 Opp Muktidham Derasar Thaltej Cross Road, SG Highway Ahmedabad, Gujarat Phone Bangalore 6th Floor, Millenia Tower 'D' 1 & 2, Murphy Road, Ulsoor, Bangalore Phone Bhubaneswar IDCOL House, Sardar Patel Bhawan Block III, Ground Floor, Unit 2 Bhubaneswar Phone / 2296 Chennai PwC Center, 2nd Floor 32, Khader Nawaz Khan Road Nungambakkam Chennai Phone Hyderabad # /82/A/113A Road no. 36, Jubilee Hills, Hyderabad , Andhra Pradesh Phone Kolkata Plot No.Y-14, 5th Floor, Block-EP, Sector-V, Salt Lake Kolkata , West Bengal Phone / Mumbai PwC House, Plot No. 18A, Guru Nanak Road - (Station Road), Bandra (West), Mumbai Phone New Delhi / Gurgaon Building No. 10, Tower - C 17th & 18th Floor, DLF Cyber City, Gurgaon Haryana Phone : Pune 'Muttha Towers' 5th Floor, Suite No. 8, Airport Road, Yerwada, Pune Phone For more information : pwctrs.knowledgemanagement@in.pwc.com The above information is a summary of recent developments and is not intended to be advice on any particular matter. expressly disclaims liability to any person in respect of anything done in reliance of the contents of these publications. Professional advice should be sought before taking action on any of the information contained in it. Without prior permission of, this Alert may not be quoted in whole or in part or otherwise referred to in any documents All rights reserved. "", a registered trademark, refers to Private Limited (a limited company in India) or, as the context requires, other member firms of International Limited, each of which is a separate and independent legal entity.