Guarantee fees, a tax deductible expense - position guaranteed!
The Federal Court of Appeal dismissed the Crown’s appeal against the ruling by the Tax Court of Canada (“TCC”), in General Electric Capital Canada Inc. v. The Queen1. The Tax Court had concluded that the guarantee fees paid annually by GE Capital Canada Inc. (“GECC”) at 1% of the outstanding debt guaranteed by GE Capital US (“GECUS”) was equal to or below the arm’s length price in the circumstances.2 The TCC ruling on transfer pricing adjustments had assumed significance from an international finance perspective as it clarified on a common intra group finance arrangement where a parent guarantees the borrowings of its’ subsidiary.
Facts and arguments advanced before the Tax Court
GECC and its indirect US based parent, GECUS were both engaged in financial services business of borrowing funds from capital markets and deploying it for onward lending on profitable terms. GECUS supported GECC by guaranteeing its debt security issuances to third party creditors. In 1995, GECUS started charging guarantee fees from GECC at 1%. GECC accordingly withheld tax and claimed deductions on such guarantee fee disbursals. The Minister of National Revenue (“Revenue”) disallowed the deductions in full under assessments made under Parts I and XIII (relating to Canadian source based taxation of non residents) of the Income Tax Act (1985) for the taxation years 1996 to 2000.
In arriving at its position, the Revenue took the view that GECC received no economic benefit from the guarantee and accordingly classified the payment of guarantee fees as dividends to GECUS as a shareholder of GECC. There were two pronged argument advanced by the Revenue. Firstly, there was an ‘implicit guarantee’ from GECUS to prevent the Canadian subsidiary from defaulting considering the latter’s strategic importance to the group and the fact that if GECC was allowed to default, it would downgrade the AAA credit rating that GECUS enjoyed, by a few notches. This could enormously increase the cost of raising debt. This would be over and above the loss to reputation and arising branding issues for GECUS. Secondly, The counsel for GECC argued that it was fundamental for a transfer pricing audit that all distortions arising out of the affiliation between the parties are ignored and the transfer pricing relationship be analysed on stand-alone basis.
The counsel on behalf of GECC, stressed in his submission that for arriving at the arm’s length price for the guarantee and not the loan, a differential needs to be arrived at between the rates at which GECC could borrow with the explicit guarantee that elevated the position to ‘investment grade’ rating and the rate sans the guarantee that rendered its debt to non-investment grade. With the differential being the benefit enjoyed by GECC, what was to be concluded was whether the fee being charged for the explicit guarantee (and not the implicit guarantee on account of the special relationship that the parties enjoyed) reflected the accruing benefit on an arm’s length basis.
Judgment and court’s rationale
The Tax Court, in arriving at its decision, relied largely on expert witnesses called by the parties including experts from credit rating space. The court further analysed obligations of GECUS (qua a shareholder) to provide capital to GECC. The court observed that GECUS would be under no obligation to fund GECC as there is no such obligation on account of limited liability of a shareholder. Justice Robert J. Hogan, hearing this matter commented that the position may have been different had the company been an unlimited liability company in which case the shareholder is jointly liable. In such cases, a separate explicit guarantee may not be required for the concerned company to raise debt.
On the moot issue of whether the guarantee was necessary, the court noted that implicit support from GECUS was akin to an invisible wallet for the corporate debt buyers of GECC but not equivalent to a legally enforceable support that guarantee affords. For these reasons, the credit rating for GECC goes up by three notches relying on the guarantee support. The court also concluded that the interest cost savings based on the rating differential works out to be 183 basis points and accordingly, a charge out rate of 1% as guarantee fee was equal to or less than the arm’s length value for the arrangement.
The grounds on which the Crown had preferred an appeal included errors of law in the transfer pricing principles that were applied and findings of fact. The Federal Court of Appeal dismissed the appeal on finding no grounds that would show the alleged error of fact or of law or the alleged bias by the tax court judge. The Federal Court accordingly allowed the TCC order that vacated the assessment orders under Part I and XIII of the Canada Income Tax Act. The confirmation was further supported by the fact that GECC had already withheld the applicable taxes due on the guarantee fee remittances for the years under consideration and based on the court’s findings, did not attract any additional tax withholdings.
Recent trends in the Indian transfer pricing landscape
The current transfer pricing regime under the Regulations does not allow for advance price agreement mechanism. In such circumstances, it is imperative that adequate documentation of commercial reasoning and accruing benefits in an intra-group transaction is done. Statistically, it has been observed that in a majority of scrutinized cases, adjustments were made on account of risk differentials where genuineness of the transaction could not be demonstrated to the concerned scrutinizing officers.
In case of assessments that are preferred for judicial scrutiny, a vast multitude of such litigations are settled at advanced ruling and appellate tribunal level. To an extent, majority of the issues that the courts are grappling with in such litigations are not adequately provided for in the current position of applicable transfer pricing legal regime.
The Canadian Tax Court in the GE case relied largely on the expert witnesses called by the parties. Questions on the independence of such witnesses towards the referring party notwithstanding, there has been an emerging trend globally (DSG Retail case in UK may be taken as an example) of engaging such witnesses in transfer pricing litigations. However, from an Indian context, though permitted under the Indian laws involvement of relevant experts in such litigations is yet to gain any ground.
The issue of intra-group funding and guarantee support for affiliated entities when an enterprise is intending to raise debt outside the group, is assuming much significance in recent times. Globally, tax authorities are gearing their transfer pricing legislations as the provision of a guarantee fee is within the realm thereof.
The focus of the ruling passed by TCC and now upheld by the Federal Court, had largely been on the debate between explicit guarantee v. implicit guarantee. The ruling was largely a compromise between the positions taken by the opposing parties. While the courts agreed with the tax authority’s position that ‘implicit guarantee’ need be considered in respect of the relationship subsisting between the affiliates, it however tilted towards GECC by agreeing that the value added by virtue of the explicit guarantee was significant enough to merit the payment of a fee in respect thereof. The ruling though pragmatic, did not settle the central issue in such transfer pricing matters – whether all factors arising on account of non- arm’s length relationship (as those between the affiliates in this case) be ignored to arrive at the arm’s length commercial.
The issues considered and arguments presented before the TCC for its ruling, which has now been upheld in appeal, highlights the level of insight that tax authorities are focusing on guarantee arrangements given its increasing size (over CA$ 136 million in this case) and its inherent potential to distort cross border flow of capital.
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1 Dockets: 2006 – 1385 (IT)G and 2006 – 1386 (IT)G
2 Para. 305 of the ruling. The court concluded based on the depositions by expert witnesses that the interest cost savings for GECC works out to be 1.83% based on the rating differential between cost of borrowing with and without the guarantee support from GECUS.