General Electric Capital Canada Inc. v. The Queen

General Electric Capital Canada Inc. v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2009-12-04
Neutral citation
2009 TCC 563
File numbers
2006-1385(IT)G
Judges and Taxing Officers
Robert James Hogan
Subjects
Income Tax Act
Decision Content
Dockets: 2006-1385(IT)G
2006-1386(IT)G
BETWEEN:
GENERAL ELECTRIC CAPITAL CANADA INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on common evidence from May 25 to June 5,
from June 9 to June 18 and on July 2 and 3, 2009, at Toronto, Ontario.
Before: The Honourable Justice Robert J. Hogan
Appearances:
Counsel for the Appellant:
Al Meghji
Martha MacDonald
Neil Paris
Joseph Steiner
Counsel for the Respondent:
Naomi Goldstein
Justine Malone
Myra Yuzak
JUDGMENT
The appeals from the assessments made under Parts I and XIII of the Income Tax Act for the 1996, 1997, 1998, 1999 and 2000 taxation years are allowed in accordance with the attached reasons for judgment, and the assessments are vacated.
The parties will have until December 18, 2009 to arrive at an agreement on costs, failing which they are directed to file their written submissions on costs no later than December 21, 2009. Such submissions are not to exceed five pages.
Signed at Montréal, Québec, this 4th day of December 2009.
"Robert J. Hogan"
Hogan J.
Citation: 2009 TCC 563
Date: 20091204
Dockets: 2006-1385(IT)G
2006-1386(IT)G
BETWEEN:
GENERAL ELECTRIC CAPITAL CANADA INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Hogan J.
SUMMARY OF ISSUE
[1] GE Capital US (“GECUS”) charged the Appellant a fee for guaranteeing its debts owing to third-party creditors. The Appellant deducted that fee in respect of its 1996 to 2000 taxation years. The Minister of National Revenue (the “Minister”) reassessed the Appellant, denying the deduction of the fee and adding Part XIII withholding tax because he believed the Appellant received no economic benefit from the guarantee and, as a result, the “arm’s length” price for the guarantee would be zero. Part XIII tax is charged on the basis that the payment of the fee is deemed to be a dividend. The issue to be determined by this Court is whether the “arm’s length” price for the service is at least 100 basis points (the Appellant’s position) or zero (the Minister’s position).
FACTUAL BACKGROUND
[2] At the commencement of the trial, the Court received a response to a request to admit the truth of certain facts (hereinafter the “statement of agreed facts”) as well as the authenticity of certain supporting documents contained in a joint book of documents. I shall reproduce in part hereunder the statement of agreed facts before summarizing the witnesses’ testimony and reviewing the relevant documentary evidence.
The Appellant and Its Position in the GE Corporate Group
1. The Appellant was originally incorporated as Genelco Finance Limited under the laws of Canada in 1963. The Appellant changed its name to Canadian General Electric Credit Limited in 1969 and to Genelcan Limited in 1973. The Appellant adopted the corporate name General Electric Capital Canada Inc. (“GE Capital Canada”) [Appellant] in 1988.
2. The Appellant has been an indirect, wholly-owned subsidiary of General Electric Company (“GE Company”) [GE], a United States company, since incorporation.
3. [GE] carried on industrial businesses and financial services businesses during the years under appeal through a large number of legal entities around the world. The corporate structure of [GE] had separate ownership groups for the industrial and financial services businesses.
4. The financial services ownership group was organized under General Electric Capital Services, Inc. (“GE Capital Services”) [GECSUS], an [sic] United States corporation that was a wholly-owned, direct subsidiary of [GE].
5. A principal subsidiary of [GECSUS] was General Electric Capital Corporation (“GE Capital US”) [GECUS], a United States corporation that was wholly‑owned, direct subsidiary of [GECSUS] during the years under appeal.
6. During the years under appeal, the Appellant was a wholly-owned, indirect subsidiary [of GECUS].
7. At all material times, the Appellant and [GECUS] did not deal with each other at arm’s length within the meaning of the Income Tax Act (the “Act”).
Business of [GECUS]
8. [GECUS] was a financial services company during the years under appeal and carried on a number of financial services businesses, as described as below.
9. In essence, [the GECUS] business model was to borrow funds from the capital markets at the lowest possible cost and then use the borrowed funds to lend or lease to other parties on profitable terms.
10. The business of [GECUS] originally related to financing the distribution and sale of consumer and other products of [GE]. By the mid‑1990s, however, the types and brands of products financed by [GECUS] and the financial services offered by [GECUS] had become significantly more diversified, and very little of the financing provided by [GECUS] involved products manufactured by [GE].
11. During the years under appeal, [GECUS] provided a wide variety of financing, asset management, and insurance products and services in the following five industry segments, directly or through its subsidiaries around the world . . . :
(i) Consumer Services — private-label and bank credit card loans, personal loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing and inventory financing, mortgage servicing, and consumer savings and insurance services;
(ii) Equipment Management — leases, loans and asset management services, including sales, for portfolios of commercial and transportation equipment, including aircraft, trailers, auto fleets, modular space units, railroad rolling stock, data processing equipment, containers used on ocean-going vessels, and satellites;
(iii) Specialized Financing — loans and financing leases for major capital assets including industrial facilities and equipment and energy-related facilities; commercial and residential real estate loans and investments; and loans to and investments in management buy-outs, including those with high leverage, and corporate recapitalizations;
(iv) Mid-Market Financing — loans and financing and operating leases for middle-market customers, including manufacturers, distributors and end users, for a variety of equipment that includes data processing equipment, medical and diagnostic equipment, and equipment used in construction, manufacturing, office applications and telecommunications activities;
(v) Specialty Insurance — financial guaranty insurance (municipal bonds and structured finance issues); private mortgage insurance; and creditor insurance covering international customer loan repayments.
Business of the Appellant
12. The Appellant was a financial services company during the years under appeal. It carried on in Canada some of the lines of financial services businesses that [GECUS] carried on in the United States and other jurisdictions outside of Canada, as described below.
13. In essence, the Appellant’s business model was to borrow funds from the capital markets at the lowest possible cost and then use the borrowed funds to lend or lease to other parties on profitable terms.
14. The Appellant was initially formed to assist in the financing of products manufactured or distributed by General Electric Canada Inc. (“GE Canada”). By the mid-1990s, however, substantially all of the products financed by the Appellant and its subsidiaries were products manufactured by companies other than GE Canada and or its affiliates, and the Appellant also provided a range of other financial services.
15. At all material times, the Appellant and its Canadian subsidiaries carried on a number of businesses in Canada. Four of the larger businesses were:
(i) a commercial and transportation equipment financing business serving manufacturers, distributors and end users with a broad range of financial products for equipment acquisitions. This business had locations across Canada and worked with the transportation, construction, printing, telecommunications, manufacturing, aeronautics and wholesale/resale distribution industries;
(ii) a fleet vehicle leasing and management business involved in the leasing and financing of automobiles, light trucks, vans, buses and medium and heavy duty trucks and trailers to business users. The Appellant and its subsidiaries also provided specialised transportation management programmes to clients relating to maintenance management, national account purchasing, fuel purchasing and insurance;
(iii) a real estate financing business for a wide range of income-producing properties, including office buildings, shopping centres, apartment complexes, condominiums, industrial buildings and warehouses;
(iv) a technology management services business, which distributed computer products and offered financial arrangements ranging from sales to day rentals, operating leases and finance type leases. The scope of products and services included personal computers, mini‑computers and test and measurement equipment supported by field technicians, networking consultants and other technology management services.
16. Other businesses carried on by the Appellant and its subsidiaries during the years under appeal included:
(i) a private label credit card business, whereby the Appellant or its subsidiary entered into and administered credit accounts with customers of participating retailers in return for programme marketing support;
(ii) an auto leasing business providing retail leasing programmes to dealers of new motor vehicles. The Appellant or its subsidiary purchased the vehicles and leases from the dealers on a non-recourse basis;
(iii) short and long term renting and leasing of over-the-road commercial semi-trailers, chassis and storage containers and mobile modular office buildings, as well as the sale and financing of such equipment;
(iv) a full service railcar leasing business offered to industrial shippers and Canadian railways. The Appellant or its subsidiary offered a range of management services to lessees including tracking mileage, arranging for leases, insurance, inspections, maintenance and repair work, as well as billing, collecting and remitting rents.
17. The Appellant’s business grew rapidly during the period under appeal . . . .
. . .
19. The Appellant (consolidated) represented between 2 to 2.3 percent of the consolidated assets of [GECUS] and between 3 and 4.4 percent of the consolidated revenues of [GECUS] during the period under review . . . .
Debt Securities
20. The Appellant’s business strategy required substantial amounts of capital, which the Appellant obtained by issuing debt in the form of commercial paper and unsecured debentures (the “Debt Securities”).
21. The Appellant’s Debt Securities were purchased exclusively by third parties unrelated to [GE] or [GECUS].
Description of Commercial Paper
22. The Appellant and its predecessor corporations issued short term promissory notes (also known as “commercial paper”) on Canadian markets from the 1970s until early 1999.
23. During the years under appeal, the Appellant issued commercial paper on almost a daily basis. [The Appellant]’s Commercial Paper Program represented at least ten percent of the Canadian corporate commercial paper market.
24. During the years under appeal, the Appellant issued commercial paper under short term promissory note programs established in 1989 and 1996 (the “Commercial Paper Program”) . . . .
25. The Commercial Paper Program prescribed a maximum aggregate principal amount outstanding of $7 billion. The actual aggregate principal amount of promissory notes outstanding during the Appellant’s 1996 to 1998 taxation years varied from a low of approximately $1.7 billion to a high of approximately $3 billion . . . .
26. The Commercial Paper Program prescribed a maximum term of 270 days for the Appellant’s promissory notes.
27. The Appellant issued commercial paper on a regular basis for a variety of principal amounts, maturities, interest rates and discounts . . . .
28. The Appellant’s commercial paper was issued in Canadian and United States dollars and traded on the Canadian commercial paper market.
29. The Appellant’s issuances of commercial paper were generally administered by financial institutions in Canada (the “Dealers”).
30. The Appellant made its final issuance of commercial paper on February 4, 1999.
Description of Unsecured Debentures
31. The Appellant issued unsecured debentures on European markets from at least 1988 until 1997 (the “Unsecured Debentures”).
32. The Unsecured Debentures typically were issued for a term of five to ten years and provided for the periodic payment of interest. The Unsecured Debentures were denominated in a variety of currencies, including Australian dollars, Canadian dollars, Luxemburg francs, Swiss francs and United States dollars . . . .
33. The Appellant issued the Unsecured Debentures under individual offerings and as part of the multi-issuer Euro Medium Term Note Program (a simpler and less costly mechanism for issuing Unsecured Debentures relative to individual offerings). In general, the Unsecured Debentures were listed for trading on the Luxemburg stock exchange. . . .
34. The Appellant’s issuances of Unsecured Debentures were fully underwritten by a syndicate of financial institutions (the “Managers” or “Underwriters”).
35. In respect of each issuance of Unsecured Debentures, the Managers agreed jointly and severally to procure subscriptions and payment for the Unsecured Debentures, or failing that, to subscribe and pay for the Unsecured Debentures on their own account. The Managers, the Appellant and [GECUS] formalised their agreement in a written Subscription Agreement . . . .
36. Subject to the Subscription Agreement, each Manager was allotted a specific amount of the Unsecured Debentures as the extent of its underwriting commitment . . . .
37. One Manager or a small group of Managers was allotted a significant amount of each issuance as its underwriting commitment (the “Lead Manager” or “co-Lead Managers”).
. . .
Management of the Debt Securities
39. The Treasury Department of [GECUS] managed the Appellant’s issuances of Debt Securities. On a daily basis, this department collected data from the Appellant’s business units and determined the Appellant’s net cash position for the day.
40. If the Appellant were short on cash for the day, the Treasury Department approached the commercial paper market through the Dealers. If the Appellant were long on cash for the day, the Treasury Department decided how much debt to repay based upon debts that were maturing.
41. The Appellant also funded its acquisitions of asset portfolios, receivable portfolios and shares in other companies with commercial paper.
42. In respect of Unsecured Debentures, the Treasury Department performed an analysis of the Canadian debt position in total, including maturity levels and the proportions of commercial paper and Unsecured Debentures. On the basis of this analysis, the Treasury Department looked for opportunities with Managers to extend the maturity of the Appellant’s debt from commercial paper into longer-term debt.
Implementation of the Guarantee
43. Prior to a corporate reorganisation in 1988, the Appellant’s issuances of commercial paper and unsecured debentures had been guaranteed by GE Canada, a Canadian company that was an indirect subsidiary of [GE] and that carried on industrial businesses in Canada at the time.
44. [GECUS] began guaranteeing the Appellant’s issuances of commercial paper and unsecured debentures after the corporate reorganisation in 1988.
45. Since 1988, including the years under appeal, [GECUS] unconditionally guaranteed payments due under the Debt Securities issued by the Appellant.
46. The full text of the [GECUS] guarantee was printed on the promissory notes issued under the Appellant’s Commercial Paper Program . . . .
47. Similarly, the full text of [GECUS]’s guarantee was printed on the notes representing the Unsecured Debentures . . . .
Credit Ratings
48. In general, a credit rating is a credit rating agency’s opinion of the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors.
49. An “issue rating” is a credit rating agency’s current opinion of the creditworthiness of an obligor with respect to a specific financial obligation, a specific class of financial obligations, or a specific financial program (including ratings on medium term note programs and commercial paper programs).
50. An “issuer rating” is a credit rating agency’s opinion of an obligor’s overall capacity to meet its financial obligations and focuses on the capacity and willingness of an issuer to meet all of its obligations as they become due.
Credit Rating Agencies
51. S&P [Standard and Poor’s] is a credit rating agency based in the United States.
52. Moody’s Investors Service (“Moody’s”) is a credit rating agency based in the United States.
53. The Dominion Bond Rating Service (“DBRS”) is a credit rating agency based in Canada.
54. The Canadian Bond Rating Service (“CBRS”) was a credit rating agency based in Canada during the years under appeal. CBRS was acquired by S&P on or around October 31, 2000.
Credit Ratings in Respect of [GECUS]
55. During the years under appeal, S&P assigned an issuer rating of AAA to [GECUS], the highest issuer rating assigned by S&P.
56. During the years under appeal, Moody’s assigned an issuer rating of AAA in respect of [GECUS], the highest rating on Moody’s credit rating scale.
Credit Ratings in Respect of the Appellant
57. During the years under appeal DBRS assigned to the Appellant’s Commercial Paper Program a public credit rating of “R-1 high”. According to the DBRS credit rating scale, commercial paper rated R-1 (high) is of the highest credit quality, indicating an entity possessing unquestioned ability to repay current liabilities as they fall due . . . .
58. In 1999, CBRS assigned to the Appellant’s Commercial Paper Program a public credit rating of “A-1 (High)”. The rating of A-1 (High) was the highest rating on the CBRS credit rating scale for commercial paper . . . .
59. S&P and Moody’s assigned credit ratings to the Appellant’s Unsecured Debentures and Commercial Paper Program during the years under appeal as part of detailed credit research and ratings reports on [GECUS] . . . .
60. No credit rating agency assigned a public issuer rating to the Appellant during the years in issue.
The Guarantee Fee
Implementation of the Guarantee Fee
61. Prior to 1995, [GECUS] did not charge the Appellant for the guarantees of the Appellant’s Debt Securities.
62. In 1995, the Appellant’s Board of Directors resolved to pay a fee for [GECUS]’s guarantees of the Appellant’s Debt Securities . . . .
63. The Appellant and [GECUS] entered into written agreements concerning the guarantee fees (“Guarantee Fee Agreements”) . . . .
64. Pursuant to the Guarantee Fee Agreements, [GECUS] agreed to guarantee the Appellant’s Debt Securities and the Appellant, in turn, agreed to pay a fee to [GECUS] equal to 1% (or 100 basis points) per annum of the principal amount of the Debt Securities outstanding from time to time during a year.
65. Guarantee fees were payable in respect of unsecured debentures issued on or after April 13, 1995.
66. In respect of commercial paper, guarantee fees were payable in respect of issuances on or after October 31, 1995 . . . .
Calculation and Payment of the Guarantee Fees
67. During the years under appeal, the guarantee fees were calculated on a quarterly basis by the Treasury Department at [GECUS].
68. The Appellant typically paid the annual guarantee fee to [GECUS] in the year following accrual.
Tax Treatment of the Guarantee Fees by the Appellant
69. In computing its income for the years in question, the Appellant deducted the guarantee fees that had accrued in each year, in the following amounts:
Taxation Year
Guarantee Fees
1996
$30,974,070
1997
$37,149,390
1998
$36,339,640
1999
$17,586,207
2000
$14,378,876
70. The Appellant withheld and remitted to the Receiver General for Canada withholding tax at the rate of 10% from the guarantee fees paid to [GECUS] in respect of the 1996 to 2000 taxation years, pursuant to paragraph 212(1)(b) and subsection 214(15) of the Act and Article XI of the Canada‑United States Income Tax Convention.
The Minister’s Assessments and Reassessments
71. In reassessing the Part I tax payable by the Appellant, the Minister disallowed the full amount of guarantee fees claimed as deductions by the Appellant, as follows:
Taxation year
Guarantee Fees Disallowed as Deductions in Computing Income
1996
$30,974,070
1997
$37,149,390
1998
$36,339,640
1999
$17,586,207
2000
$14,378,876
72. The Minister made the following assessments of the Appellant’s tax payable under Part XIII of the Act (collectively, the “Part XIII Assessments”):
Notice of Assessment Number
Notice of Assessment Date
Taxation Year‑End
Adjustment to Part XIII Tax
6240554
March 11, 2004
December 31, 1996
$1,548,704
6240555
March 11, 2004
December 31, 1997
$1,857,470
6240556
March 11, 2004
December 31, 1998
$1,816,982
6240557
March 11, 2004
December 31, 1999
$879,310
6240558
March 11, 2004
December 31, 2000
$718,944
. . .
[3] The Appellant called 13 witnesses, seven of whom were qualified as expert witnesses. The Respondent called seven witnesses, five of whom were qualified as expert witnesses.
SUMMARY OF APPELLANT’S WITNESSES’ TESTIMONY
Testimony of Roman Oryschuk
[4] Mr. Oryschuk testified that he was the president and CEO of GE Capital Solutions (“GECS”), a Canadian subsidiary of the Appellant, during the taxation years under review. Previously, he had run the equipment leasing business for the National Bank of Canada, and he became a GE employee when that business was sold to the Appellant.
[5] He was responsible for the Canadian business operations of the entity. He led a very dynamic sales team which was able to expand the mid-market equipment leasing business of the Appellant over the taxation years in question. He was not responsible for meeting the financing needs of the business. That function was performed by GECUS, the guarantor of the Appellant’s debt.
[6] The operations of the Appellant expanded rapidly over the period in question. The total assets of the business grew from $1.3 billion as Mr. Oryschuk’s arrival to approximately $5 billion when he left to take on his new duties in Europe for a GE affiliate.
[7] Mr. Oryschuk testified that, similar to the situation in all of the GE enterprises, he had operational autonomy provided his operations could meet the financial benchmarks all GE entities were expected to meet. In the GE culture, an annual review was performed to determine growth prospects for the business, new markets, etc. If the Canadian operations failed to meet their financial targets, it was clear in the witness’s mind that the businesses could be sold or wound down. According to the witness, this could be done through a sale of the assets backing a particular loan or leasing portfolio, or of the entire business if the problem was more general in nature.
[8] Mr. Oryschuk further testified the AAA rating obtained by the Appellant had an impact on his company in that it allowed funds to be obtained at competitive rates.
Testimony of Jeffrey Werner
[9] Mr. Werner testified that GE, headquartered in Fairfield Connecticut, was the parent of 12 separate lines of business, which ran independently of each other. Of these lines of business, 11 were considered part of the industrial businesses, e.g. aircraft engines, major appliances, plastics, etc. The remaining business line was the financial services business.
[10] Within the financial services business, GE held all the shares of GECSUS, a holding company for the entities in this particular business line. GECSUS, in turn, held shares in GECUS, GE Global Insurance Holding Corp. and Employer’s Reinsurance Corp.
[11] The main purpose of GECUS was to fund the operations of affiliated companies by issuing commercial paper and unsecured debt instruments. After raising the funds needed, GECUS would provide those funds to the affiliates through intercompany transfers.[1] To avoid liquidity problems, GECUS maintained backup lines of credit in an amount equal to 50% of its outstanding commercial paper. GECUS handled all the treasury functions for all of the businesses within the GE Capital group, including the Appellant.[2]
[12] After the reorganization in 1988, the Appellant became an affiliate of GECUS. The guarantees that were provided by the Appellant’s former Canadian parent (GE Canadian Holdings Ltd.) remained with the Canadian parent[3] and GECUS began to provide guarantees to secure the Appellant’s debt around April 1989.[4] There were no guarantee fees charged by GECUS from 1988 until 1996, the first taxation year under appeal.
[13] Although no fee was charged initially, as part of a transfer pricing review Mr. Werner was asked to make a recommendation to Mr. Jim Parke, CFO of GECUS, as to what guarantee fee the Appellant should be charged. Mr. Werner ultimately recommended a guarantee fee of 100 basis points (1%) of all new debt issued.
[14] In determining the guarantee fee to be charged, Mr. Werner testified, he understood the fee had to be an arm’s length price.[5] Mr. Werner compared the rates that the Appellant would be able to obtain if it could borrow with the guarantee (investment grade rating) with the rate at which it could borrow without the guarantee (a non-investment grade rating).[6] This method is referred to as the yield curve approach and it reflects the costs of borrowing money given various maturities and different credit ratings. The differential or spread was determined to be between 100 and 300 basis points (1% to 3%).[7]
[15] The guarantee fee of 100 basis points (1%) was ultimately recommended by Mr. Werner since he believed it accurately represented the benefit the Appellant had been enjoying. Moreover, had there been arm’s length negotiations, the Appellant would have kept some of the benefit for itself.[8]
[16] Mr. Werner testified that he did not believe the Appellant would have been rated AAA without the guarantee.[9] He denied GECUS would necessarily have supported the Appellant’s operations; more precisely, he claimed that GECUS could have just walked away if there was no explicit guarantee in place.[10]
[17] During cross-examination, Mr. Werner conceded that its AAA rating was very important to GECUS.[11] GECUS, as an unregulated financial services company, did not have access to low‑cost borrowings made available through deposits, to which banks do have access. Accordingly, GECUS and the Appellant were principally reliant on credit markets.[12] In the commercial paper market, they had to constantly roll over commercial paper.
[18] Mr. Werner admitted that GE valued its reputation, as stated in its public filings. He also admitted the Appellant used some of the same dealers and underwriters as those that are used by GE subsidiaries throughout the world to issue its commercial paper and bonds.[13]
Testimony of Laurence Booth, Ph.D.
[19] Dr. Booth has a bachelor’s degree in science and economics from the London School of Economics, an M.A., an M.B.A. and a Ph.D. in business administration from Indiana University.[14] He is a professor of finance at the University of Toronto, holds the CIT Chair at the Rotman School of Management, and is in charge of the investment banking track in the MBA program at the University of Toronto.[15] His experience includes acting as an expert witness in financial and capital market matters, mainly with regard to regulated industries.[16] Specifically, in the case at bar, Dr. Booth was asked to give an opinion on:
(a) whether it was prudent and reasonable for the Appellant to obtain a guarantee from GECUS; and
(b) what the market value of that guarantee was.[17]
[20] Dr. Booth acknowledged that he is not an expert in establishing credit ratings and stated that he was not asked to do so. In fact, he noted that most U.S. or multinational parents guarantee the debt obligations of their Canadian subsidiaries.[18]
[21] Unregulated financial services companies usually operate without a captive retail deposit base. Conversely, regulated banking institutions have extensive retail networks and generate a significant amount of their funds from customers’ deposits which, in turn, are covered by the Canada Deposit Insurance Corporation. This allows banks to have a large source of low‑cost and stable funds.[19] Without a guarantee, financial services companies such as the Appellant would be competing at a significant disadvantage. According to Dr. Booth, the Appellant would not, in the absence of the guarantee, have been able to raise capital as it did.
[22] Dr. Booth maintained that the guarantee also offered other advantages to the Appellant; for instance, it did not have to pay placement fees when issuing commercial paper through the dealer network. In addition, the Appellant avoided the need for backup lines of credit, which would have been required if the debt was not guaranteed. Typically, 100% of an issuer’s commercial paper must be supported by backup lines of credit to guard against the refinancing risk that arises during periods of financial instability where investors look to government-issued treasury bills and the like. The Appellant did not have to negotiate backup lines of credit because GECUS was viewed as the ultimate creditor and had arranged for the availability of such credit facilities. That arrangement coupled with the explicit guarantee allowed the Appellant to piggyback on the sterling credit rating of GECUS.
[23] Dr. Booth testified that he was of the opinion that the Appellant could not have received a AAA rating or an R-1 high commercial paper rating without an explicit guarantee from GECUS.[20] The guarantee and the rating allowed the Appellant’s commercial paper to be virtually risk free, similar to treasury bills.[21] The guarantee meant the Appellant could raise significant sums of money several times a day, over the telephone, from a variety of investors.[22] Dr. Booth admitted that the GE name alone would “notch up” the credit rating; however, he believed it extremely unlikely that this would have got the Appellant a credit rating sufficient to permit access to the commercial paper and swap markets in the volumes the Appellant needed to finance its Canadian operations.
[24] Dr. Booth acknowledged the capital markets would be shocked if GECUS allowed its Canadian subsidiary to default, assuming it had not guaranteed the Appellant’s indebtedness. However, Dr. Booth advanced two circumstances in which the parent could allow a subsidiary to default: a single episodic shock that causes a huge loss of money or a gradual deterioration of the business.[23] Dr. Booth pointed out that it was the economic value of the subsidiary that was important, not whether it had the same name as, or was considered a “core” or “strategically important” subsidiary of, GECUS. Dr. Booth asserted that if the parent’s economic incentive is to walk away, then the parent will walk away, thereby changing any classification, e.g. core or strategically important, that the subsidiary may have.[24]
Testimony of Brian Neysmith
[25] Mr. Neysmith, now retired, was one of the co‑founders of CBRS in 1973. After the company was sold to S&P in 2000, he remained with S&P until January 2003.[25] His main responsibility, after CBRS was sold, was to “merge the two companies together to harmonize the rating criteria [and] the rating methodology”.[26] Mr. Neysmith was the person who “signed off” on, and authorized the issuance of, new ratings.[27]
[26] During the relevant period, CBRS’s share of long‑term debt and commercial paper rating in the Canadian medium-term market was significant; for example, in the commercial paper market CBRS held between 50% and 60% of the rating business.
[27] Mr. Neysmith stated that both CBRS and DBRS approached credit analysis from the same fundamental basis: looking at the ongoing financial condition of the company and its history.[28] Even though the ratings were similar in about 75% of the cases, the companies and issuers would usually request both: CBRS and DBRS.[29]
[28] Mr. Neysmith testified that CBRS would not have given the Appellant a AAA rating without GECUS’ guarantee. According to the witness, CBRS would have rated the Appellant lower than A+ or A-1 high.
Testimony of Mark Fidelman
[29] Mr. Fidelman is an economist currently employed as a tax director at Deloitte Tax LLP in the U.S. His expertise pertains to transfer pricing and insurance industry pricing.[30]
[30] Mr. Fidelman used a model designed for pricing insurance products for the purpose of determining an arm’s length price for the guarantee.
[31] According to the witness, a debt guarantee can be viewed as a form of credit insurance. Financial guarantees are sold as insurance products to improve creditworthiness with respect to both public-sector and private‑sector debt. Examples of public entities in the U.S. availing themselves of financial guarantee insurance on debt issuances are municipalities with regard to economic development and general revenue bonds.[31]
[32] According to Mr. Fidelman, the stand-alone credit rating of the Appellant during the valuation period was in the range of BB to BB+ under an insurance pricing model.[32]
[33] According to the witness, an insurer would not take into account the benefit of an “implicit guarantee” from a subsidiary’s parent when pricing insurance. As an insurer would expect to be asked to pay out under credit default insurance if the debtor defaulted, the insurer would not expect the debtor’s parent to pay out on the basis of implicit support and, as a result, would take no account of an implicit guarantee when establishing an appropriate premium for the product.
[34] Asked to comment on a Respondent’s expert, Dr. Saunders, Mr. Fidelman asserted that the expected loss cost is just one component of the total guarantee fee charged that would meet the requirements of the arm’s length principle, and that the other major component is a return on risk capital.[33] Mr. Fidelman disagreed with the calculation by Dr. Saunders that was based on the Basel II regulatory regime. In the first place, Basel II was not in place during the years under study; rather, Basel I was applicable during that period.[34]
[35] Basing his opinion on the insurance pricing methodology, Mr. Fidelman concluded that the 1% fee charged the Appellant by GECUS does not generate the return on capital an insurer would demand for an insurance-based guarantee. On this basis, the fee paid by the Appellant does not exceed what would be charged in an arm’s length relationship.
Testimony of John Frederick Coombs
[36] Mr. Coombs is a banker holding the office of vice‑chairman of TD Securities and senior vice-president of TD Bank Financial Group, head of Europe and Asia Pacific.[35] This witness was qualified as an expert in banking and credit matters.[36] He was not qualified as a transfer pricing or credit rating expert.
[37] Mr. Coombs concluded the Appellant would not have been able to borrow the amount of funds it did in the Canadian commercial paper market without GECUS’ guarantee.[37]
[38] Mr. Coombs testified the Appellant’s debt-to-equity ratio was higher than that of other independent companies in the market. The Appellant’s ratio was between 10 to 1 and 12 to 1 whereas other unregulated financial institutions had ratios between 5 to 1 and 8 to 1. On the basis of this factor alone, Mr. Coombs believed the Appellant would not have been rated investment grade.[38]
[39] Without a formal guarantee from the parent company, Mr. Coombs asserted, Canadian banks would have extended only limited credit facilities to the Appellant. Those facilities would have been short-dated (in the 3- to 12-month range) foreign exchange, derivative and operating credit facilities in amounts ranging up to perhaps $100 million in total.[39] The inference made by Mr. Coombs was that the Appellant would not have been able to negotiate large enough backup lines of credit to support its commercial paper program without the guarantee by its parent and, as a result, the Appellant would not have been rated investment grade.
[40] Mr. Coombs maintained that his opinion would not be influenced by the fact that a credit rating agency may have been willing to give the issuer an investment grade rating. Banks generally use the public debt ratings as a guideline or ceiling, but assign internal ratings based on their own fundamental analysis. TD Securities frequently assigns internal risk ratings below those determined by rating agencies. Banks would provide some accommodation, but Mr. Coombs did not believe the kind of accommodation given would have been sufficient for the Appellant to operate its business during the relevant period.[40]
[41] In his opinion, without the guarantee, the Appellant would not have been able to obtain from banks the backup lines of credit required in order to get a DBRS or, at the time, CBRS, investment grade rating.[41]
[42] Mr. Coombs dismissed the implicit guarantee argument, reasoning that if the parent would never let the Appellant fail, Canadian banks would expect the commitment to be backed up by a formal guarantee.[42]
Testimony of William John Chambers, Ph.D.
[43] Dr. Chambers has been a professor at Boston University since 2005. He received a B.A. from College of Wooster in 1968 and an M.A., an M.Phil. and a Ph.D. in economics at Columbia University, the latter degree having been conferred in 1975.[43] He began his career with S&P in 1983 and held a number of senior positions with the company until he left in 2005.
[44] Dr. Chambers was asked to opine on the credit rating of the Appellant for the taxation years under review, assuming its indebtedness was not guaranteed by GECUS. He was instructed to use for this purpose the S&P rating criteria and methodology applicable in the years in question.[44]
[45] Dr. Chambers explained that in preparing a credit rating for a company that is a subsidiary of another, S&P first determines the stand-alone creditworthiness of the parent and the subsidiary. At this stage, Dr. Chambers asserted, the rating agencies take into account the relationship between the parent and the subsidiary in terms of the management services and expertise provided by the former, and their common name.[45] However, neither S&P nor Moody’s would take into account the possibility that the parent might inject funds into the subsidiary or provide financial support through a different means.[46]
[46] Dr. Chambers concluded that the stand-alone creditworthiness of the Appellant, using the S&P rating criteria, would have been a single B+ or a BB- during the relevant period.[47]
[47] There was much confusion during the trial regarding the distinction between a stand-alone and status quo rating. My understanding was that both of these ratings look at the subsidiary as a separate business as opposed to part of an integrated group. However, the distinction between the two is that the status quo rating takes into account the benefits of the common name, the parent’s management team and existing business arrangements, such as intercompany loans. The stand-alone rating abstracts from these conditions. Because Dr. Chambers takes these elements into account, his first step results in a status quo rather than stand-alone rating.
First Step: Analysis of the Appellant on a Stand-Alone/Status Quo Basis
[48] Dr. Chambers assigned a B+ to BB- rating to the Appellant for various reasons. The Appellant was a profitable e