Building a Defense to Avoid Double Taxation

Documentation and transparency is the best way to satisfy the tax authorities by showing that fees are consistent with the arm's-length standard and avoid the risk of being double taxed.

The issue of intercompany guarantees is something a lot of national tax authorities are looking at closely these days, and often with differing views. Companies looking to expand foreign operations through acquisitions using parent company guarantees need to take care as this topic continues to heat up with authorities.

Imagine that a U.S-based multinational expanded its foreign operations through an acquisition of another company, and financed that acquisition with debt incurred by its foreign affiliates. If this financing involved an intercompany guarantee from the U.S. parent (keeping the interest rate low), the IRS would expect compensation for the provision of this intercompany guarantee. The issue of intercompany guarantee fees has generated controversy in the tax and transfer pricing arena as other tax authorities—especially the Canadian Revenue Agency (CRA)—tend to view the appropriate treatment of intercompany guarantee fees differently, which risks double taxation.

In Burlington Resources Finance Co. v. Her Majesty the Queen,the CRA is attempting to deny intercompany deductions for guarantee fees paid by the Canadian affiliateto its U.S. parent. This Canadian affiliate borrowed $3 billion in early 2002 to finance the acquisition of certain Canadian oil and natural gas assets. The average intercompany deduction over the next four years was almost $21 million per year, or 0.7% of the third-party loans.

The Court is framing this issue in terms of whether the explicit guarantee allowed the Canadian affiliate to obtain a better credit rating than it would have received with only an implicit guarantee from the U.S. parent. This is how the decision in a similar case, General Electric Canada Co. v. The Queen, was favorably resolved in terms of General Electric Canada. In the Burlington case, the Court rejected the argument from the taxpayer that the Canadian affiliate was unable to borrow funds on a stand-alone basis, was unable to carry out financing activities without an unconditional guarantee from its U.S. parent, and could not obtain a proper credit rating without the guarantee. The Court is asserting that a trial will be necessary to determine what a reasonable guarantee fee would have been under the arm’s-length standard.

While the most recent Court ruling does not mention the terms of the third-party loans, one 10-K filing for Burlington Resources notes:

In February 2002, Burlington Resources Finance Company (BRFC) issued $350 million of 5.7% Notes due March 1, 2007 (February Notes), which were fully and unconditionally guaranteed by BR.

In other words, the Canadian affiliate was able to secure a five-year loan at an interest rate that exceeded the interest rate on five-year government bonds at the time by 1.3 percent, which was consistent with an AA credit rating. Combined with the 0.7 percent guarantee fee, the Canadian operations were effectively paying a 2 percent credit spread. At issue in this trial will be whether the credit rating of the Canadian operations, in the absence of this explicit guarantee, would be such that a third-party bank would have charged that much in terms of a credit spread.

This kind of scrutiny and litigation is happening all over the world, as tax authorities have differing views on these issues. The risk of double taxation is very real for any company with these common kinds of transactions. In this case, a credible and complete transfer pricing analysis would most likely satisfy the expectations of the Court and settle the matter.

Companies going into these transactions would be well advised to prepare a proper transfer pricing analysis. The controversy surrounding transfer pricing makes audits likely. Documentation and transparency is the best way to satisfy the tax authorities by showing that fees are consistent with the arm’s-length standard and avoid the risk of being double taxed.

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Carla Yrjanson

Carla Yrjanson is the Vice President of Tax Research & Content for Indirect Tax within Thomson Reuters. She leads the Tax Research & Content Team which is responsible for delivering Sales/Use...

J. Harold McClure

Dr. James Harold McClure, senior manager of transfer pricing at Thomson Reuters, has over 18 years of transfer pricing and valuation experience and has authored a number of papers on the subject....
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