A corporation (“ENMAX”) that was wholly-owned by the City of Calgary and thus, exempt from income tax, made a subordinated loan of $497M with a term of 10 years and bearing interest at 11.5% per annum to an electricity-distributing wholly-owned subsidiary of ENMAX (“Energy”), and made two similar loans for $309M and $59M bearing interest at 10.3% and 9.9%, respectively, to a subsidiary of Energy (“PSA”) to fund its acquisition of rights to power. Energy and PSA were required by s. 147(3) of the Utilities Act (Alberta) to make “Balancing Pool Payments” (for the ultimate benefit of Alberta energy consumers) equal to the federal and Alberta income tax for which they would have been liable had they not been exempt from income tax. The Alberta Minister of Finance reassessed Energy’s and PSA”s calculation of their Balancing Pool Payments on the basis that the reasonable rate of interest required by s. 20(1)(c)(i)) on the above loans was 5.42%, 5.26%, and 5.24%, respectively.
After indicating (at para. 74) that the Legislature had incorporated the ITA regime “in pursuit of a specific goal: competitive equivalency between municipally-owned and non-municipally-owned companies,” and noting (at para. 77) that “in marked contrast to the ordinary situation under the ITA where a parent has loaned money to a subsidiary” under which “the interest deductible by the subsidiary is brought into income by the parent,” the Court stated (at para. 79) that:
What is reasonable for purposes of calculating taxable income is not necessarily reasonable for purposes of calculating a required Balancing Pool Payment.
Then turning to the reasonableness test under s. 20(1)(c)(i), the Court stated (at paras. 99, 103):
An arm’s length assessment constitutes a necessary proxy for the reasonableness of the interest deduction. …
A parent of a municipal entity is not entitled to gain an advantage over its private competitors by arranging its subsidiaries’ affairs in a way that causes a hypothetical arm’s length loan to appear riskier than it would have been had any reasonable municipal entity actually gone into the market to borrow the funds. Hence the need under the Balancing Pool Payments regime to ensure that the structure of the loan transaction is also objectively reasonable to the extent it would affect a market interest rate.
In accepting the view of the Minister’s experts that the interest rate on a hypothetical arm’s length loan to Energy or PSA would reflect implicit credit support from ENMAX, the Court noted (at para. 113) that “ENMAX would hardly stand idly by while subsidiaries that represented at least half of its net income were forced into insolvency or into the sale of key assets,” and (at para. 116):
[A]ny third party lender would look at the entire corporate structure and see that ENMAX’s viability could not be separated from that of its subsidiaries. An external lender would therefore assume implicit parental support.