Transfer Pricing for Inter-Company Transactions Clarified in GE Capital v The Queen
On December 4th, the Tax Court of Canada released its decision in General Electric Capital Canada Inc v The Queen, 2009 TCC 563 [GE Capital], dealing with transfer price deductions. GE Capital was anticipated as a major decision relating to transfer pricing and inter-company financial transactions. Consequently, the court conducted a thorough analysis of the different transfer pricing methodologies and examined the testimony of employees of the Appellants’ subsidiaries and expert witnesses in detail.
One of the main questions that the case attempted to answer was how the transfer price should be calculated between “arm’s length” parties. The discussion of this issue had international relevance, especially for companies investing in Organisation for Economic Co-operation and Development (“OECD”) countries, because of the decision’s reference to the OECD Transfer Pricing Guidelines.
The courts set out a complex and multi-step framework for determining “arm’s length” prices. Nonetheless, the courts noted that the framework was merely a guideline and any decision in subsequent cases will be dependent on the facts and circumstances surrounding the particular case.
Transfer Pricing Rules in Canada
Transfer Prices are fees that companies charge for trading goods and services with their subsidiaries in foreign markets. According to tax law in Canada, the transfer price should be the price of the goods or services if the parties were dealing at arm’s length, known as the “arm’s length principle.” The arm’s length principle was ratified and formalized in Article 9 of the OECD Model Tax Convention, which states:
[w]here conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
However, determining arm’s length transfer prices is very subjective. Courts look at a variety of factors, including a company’s activities, risks, characterization of entities and comparability of arm’s length with non-arm’s length transactions. This principle was further clarified and elaborated in GE Capital.
To fund its operations, General Electrical Capital Canada (“GECC”) (the Appellants) relied on wholesale funding through the commercial paper market in Canada. General Electric Capital United States (“GECUS”) provided GECC an explicit guarantee and charged them a fee for guaranteeing its debts owing to third party creditors. GECUS provided the explicit guarantee from 1988 onwards, but only charged a fee from 1996. GECC deducted the fee, amounting to $196 million, in their income tax returns from 1996 to 2000. The Minister of National Revenue reassessed GECC’s return and denied the deduction of the fee, deeming the “arm length” price to be zero since GECC received no economic benefit from the guarantee.
The Minister claimed that GECC could have borrowed the same amount without an explicit guarantee. GECC argued that the benefit they received was the ability to borrow large amounts of capital at interest rates offered to AAA credit rating holders.
The issue determined by the court was whether the “arm’s length” price was 100 basis points (GECC’s position) or zero (the Minister’s position).
Business Judgment Rule Validated
The court decided in favor of GECC, allowing them to claim the 100% of the deductions. The guarantee fee of 100 basis points was held to be an arm’s length price.
The court in GE Capital conducted a detailed analysis of the testimony of employees of GECC and its subsidiaries. The court relied on the testimony and business judgment of Jeffrey Werner, the treasurer of GECUS, to conclude that the guarantee was an essential part of the business. The court stated that it would “exercise caution before adopting conclusions that contradict the properly exercised business judgment of taxpayers.” They relied on the expert’s opinion based on his experience in the “business trenches.”
Role of Expert Witnesses
The court also considered the role of expert witness testimony in the determining the outcome of a case. An expert’s opinion has to be “unbiased” and “relevant to the subject matter of the case.” Judges have to ensure experts are acting in conformity with their role and ensure that the expert’s testimony is not prejudicial to the interest of justice. Historically, Canadian courts have given little weight to expert evidence. But an objective, neutral and independent expert analysis should be accorded significant weight, unless declared inadmissible at the outset.
Arm’s Length Price
The court determined that the parties were related and not dealing at “arm’s length” because GECUS had de jure control over GECC.
The court stated that “the expressions ‘arm’s length’ and ‘non-arm’s length’ are creations of law. They are not words of ordinary language from which a plain meaning can be easily distilled.” The court then turned to “the textual, contextual and purposive analysis to clarify the expression in the context of transfer pricing.”
Citing Galaxy Sports Inc (Re), 2004 BCCA 284, the court defined arm’s length to mean “no bonds of dependence, control or influence, between the corporation and the person in question.” Court’s determined that the market price for “arm’s length” transactions refers to independent parties in the marketplace would behave – balancing the seller’s objective of getting the highest price with the buyer’s goal of acquiring the goods at the lowest price. The main question was to identify the economically relevant transactions that may influence the arm’s length parties in their decision.
The court also cited the ruling in GlaxoSmithKline Inc v The Queen, 2008 TCC 324, which noted that:
The Commentary [the OECD Commentary on Article 9(1)] recognizes that transfers between MNEs [multinational enterprises] do not necessarily represent the result of market forces, but may instead have been adopted for the convenience of the MNE. Consequently, prices set by an MNE may differ significantly from the prices agreed upon between unrelated parties engaged in the same or similar transactions under the same or similar conditions.
After conducting a detailed analysis of the different methodology for determining the arm’s length price, the court concluded that the yield approach is the best approach in the circumstances. The yield approach calculates the benefit to GECC as a result of the guarantee by evaluating the cost of interest between a guaranteed and unguaranteed debt. The court deferred to the business judgment of Mr. Werner who used the yield approach to determine the arm’s length price.
The court concluded that the benefit that GECC received in the transaction was in the form of reduced interest rates due to GECUS’s AAA credit ratings. The interest cost savings was calculated to be 1.83%. The court held that the guarantee fee of 1% charged by GECUS is equivalent to the arm’s length price.
The court maintained that taxpayers should not make general assumptions from this particular case because differences in economic considerations can lead to different results in different situations. “[T]ransfer pricing is largely a question of facts and circumstances coupled with a high dose of common sense.”
However, this decision may nonetheless have an impact in the everyday transactions between arm’s length and non-arm’s length parties when calculating the arm’s length price of the transaction. The court considered the insurance-based method and the CDS methodology to be unreliable and uncertain. Companies using these methodologies may have to incur the cost of reassessing their current prices and implementing the new prices based on the yield approach. They should take a closer look at transactions between their subsidiaries or arm’s length parties and determine whether additional analysis or change is necessary to meet the common law requirements for inter-company transactions.
It is important to note that the court deferred to the business judgment of the executives when making the decision of that methodology to implement. Companies may rely on the expert testimony and business judgment of experienced executives to avoid liability in these circumstances. Due to the complicated nature of these transactions, judges are not the most qualified to analyze and assess the transactions and they should not be interfering with the business decisions made by the company. The GE Capital decision seems to be supporting this view. However, the courts have absolute discretion to disregard business judgment rule in situations of fraud or bad faith.
The courts also stated that arm’s length transactions do not require a strict separation of the parties involved. The courts have to look at a number of different economic considerations that may influence the price, including the volatility of the market, risk of the transaction, and overall business environment.