ENMAX Energy Corporation v Alberta, 2016 ABQB 334

Court of Queen ’ s Bench of Alberta Citation: ENMAX Energy Corporation v Alberta, 2016 ABQB 334 Date: 20160617 Docket: 1001 17672, 1101 05515, 1301 08510, 1301 08511 Registry: Calgary Action No: 1001 17672, 1301 08511 Between: ENMAX PSA Corporation Plaintiff - and - Her Majesty the Queen In Right of Alberta Defendant Action No: 1101 05515, 1301 08510 Between: ENMAX Energy Corporation Plaintiff - and - Her Majesty the Queen In Right of Alberta Defendant Corrected judgment: A corrigendum was issued on June 22, 2016; the corrections have been made to the text and the corrigendum is appended to this judgment. _______________________________________________________ Reasons for Judgment of the Honourable Mr.

Justice G.H. Poelman _______________________________________________________ Table of Contents I Introduction . 3 II Basic Facts and Issues . 4

A. Introduction . 4 B. The Electric Utilities Industry and ENMAX .. 5 C. Credit Ratings and the Pricing of Debt 9 D. ENMAX Pricing Documents . 11 1. Introduction . 11 2. 2004 Intercompany Note . 11 3. 2006 Intercompany Note . 12 4. 2007 Intercompany Note . 13 E. Questions for Determination . 13 III Principles of Law .. 13 A. Statutory Framework . 13 B. The Assessments and Appeals . 14 C. Statutory

Interpretation . 14 D. Effect of PILOT Reg. 15 E. ENMAX’s Pricing Process . 16 F. “Reasonable” Amount of Interest Deduction . 17 1. General Principles . 17 2. Transaction to be Assessed . 18 3. Arm’s Length Comparators . 19 4. Range of Reasonableness . 20 G. Burdens of Proof . 20 IV Evidence . 21 A. Expert Witnesses . 21 1. Introduction . 21 2. ENMAX witnesses . 21 a. Robert Weiss . 21 b. Gregory Johnson . 22 3. Crown witnesses . 22 a. David Levey . 22 b. David Goldreich . 23 c. Bradley Wendt 23 d. Eric Powers . 24 B. Expert Evidence . 24 1. Credit rating . 24 a. Business risk and financial risk . 24 b.

Implied credit profile and parental support 26 c. Nature of the debt 27 d. 2006 and 2007 notes . 28

e.

Summary . 29 2. Pricing . 29 a. Benchmarks . 29 b. Fundamental factors . 31 c. Comparison of experts . 34 C. Discovery Evidence . 34 V Findings . 35 A. Introduction . 35 B. The Transaction to be Measured . 35 C. Arm’s Length Check on Reasonableness . 36 1. Introduction . 36 2. Credit Rating . 36 3. Pricing . 38 4.

Summary of Arm’s Length Check . 40 D. Conclusions . 40 VI Judgment 42 I Introduction [ 1 ] As a result of deregulation of the electrical utility industry in Alberta, a number of government-owned utilities became competitors of commercial corporations. One of these was ENMAX Corporation (“ENMAX Corp.”), owned by the City of Calgary and providing services formerly offered by the City of Calgary’s Electric System.

ENMAX Corp. operates through a number of subsidiaries, including the two appellants in this case, ENMAX Energy Corporation (“ENMAX Energy”) and ENMAX PSA Corporation (“ENMAX PSA”). (For convenience, the group of ENMAX corporations will sometimes be referred to as “ENMAX,” and ENMAX Energy and ENMAX PSA will sometimes be referred to as “the appellants.”) [ 2 ] The Government of Alberta needed to address the inequity that would result from the fact that government-owned entities are usually exempt from provincial and federal tax statutes, while privately-owned and publicly-traded corporations are taxable.

The government established a system that required government-owned businesses such as the appellants to make payments into a “balancing pool”; these “payments in lieu of tax” or “PILOT” payments are calculated in accordance with the tax statutes. One of the deductions available when calculating federal taxes is a “reasonable amount” of interest on borrowed money used for the purpose of earning income. [ 3 ] ENMAX Corp. advanced a series of intercompany loans to its subsidiaries, ENMAX Energy and ENMAX PSA.

Those companies then deducted the interest payments on those loans when calculating their payments in lieu of tax. [ 4 ] Alberta’s Minister of Finance reassessed the PILOT tax returns pursuant to his authority under the legislation and regulations and concluded that the amounts of interest deducted were too large to be reasonable. The interest deducted was at a rate of about 10% annually, while the Minister said that about 5% was reasonable.

The appellants challenge the reassessment, leading to a trial in this court (the procedure by which appeals from reassessments are conducted). [ 5 ] The parties presented extensive evidence, much of it through expert testimony. There were also many exhibits and extensive written and oral argument. Central to the parties’ competing positions is what test should be used to determine what is meant by a reasonable amount of interest and how to determine today what would have been reasonable under loans advanced in 2004, 2006 and 2007.

That, in turn, involved expert construction of notional credit ratings that formed the primary underpinning for determining reasonable rates of interest. II Basic Facts and Issues A. Introduction [ 6 ] Many of the facts are not disputed. The issues primarily concern how to interpret and apply those facts to the question of whether the amounts of interest sought to be deducted are reasonable. [ 7 ] I will thus begin by outlining the main facts underlying the dispute. Many of these were covered by an Agreed Statement of

Partial Facts. Where that is the case, I will select from, summarize and paraphrase that lengthy document. [ 8 ] I will also draw from the evidence of Mr. John Mulligan, acting chief financial officer and vice-president and treasurer of ENMAX Corp., who gave evidence in a fair, straightforward manner. He joined the ENMAX organization in 2012 and holds the same offices with the subsidiary companies, ENMAX Energy and ENMAX PSA. [ 9 ] Neither Mr. Mulligan nor any other ENMAX Corp. finance department employees were employed by ENMAX Corp. during the relevant period of approximately 2004 through 2009.

He had the unenviable task of repeating facts from the plaintiffs’ documents, although he has no reason to think any of them are inaccurate. Both parties questioned him extensively on matters in which he had no personal involvement, without objections to the obvious limitations of this type of evidence. Mr. Mulligan acquitted his role as credibly and reliably as could be expected given his lack of personal knowledge of the issues pre-dating his time at ENMAX. B.

The Electric Utilities Industry and ENMAX [ 10 ] The main components of the electricity industry are generation, transmission, distribution and retailing. [ 11 ] Generation is the production of electricity. Electricity is generated at a large number of plants in Alberta using a variety of fuel sources and technologies, including coal, natural gas, co-generation, hydro and wind.

Generally speaking, the bulk of generation is in the northern part of the province, while the largest demand is in the south, so a substantial transmission infrastructure is required to move electricity to the cities and larger “loads” or consumers. [ 12 ] Transmission is the transport of generated electricity over high voltage wires known as transmission wires covering long distances. Because of the physical properties of electricity, transmission is performed mainly by a single firm in any area of the province.

After transmission to a city or municipality, a local distributor delivers the power to homes and businesses along distribution wires. [ 13 ] Under the Electric Utilities Act , S.A. 2003, c E-5.1, first enacted in 1995, owners of the provincial transmission grid, including ENMAX Corp., retained ownership of their respective components of the grid, but access to the grid was dedicated exclusively to an independent, government appointed transmission administrator (now the Alberta Electric System Operator, “AESO”). [ 14 ] Distribution is the transport of electricity between main transmission wires and residential houses or commercial and industrial businesses.

Distribution uses distribution wires, which are smaller and not as high voltage as transmission wires, the electricity to be distributed having had its voltage lowered by transformers in substations between the transmission wires and distribution wires. [ 15 ] Retailing is the sale of electric power to consumers (the electricity having been generated in generation and transported in transmission and distribution). [ 16 ] The process of deregulation started in 1990, when the Province began a policy review of the Alberta power industry.

Prior to 1996, the entire electricity system in Alberta was regulated pursuant to provincial legislation. [ 17 ] The power industry in Alberta features privately-owned and municipally-owned enterprises and has done so for many years. Prior to deregulation, substantially all of the provincial generation was supplied by three regulated generating companies (ATCO Electric, EPCOR and TransAlta Utilities). [ 18 ] Commencing January 1, 1996, under the Electric Utilities Act , the Province took significant steps towards deregulation.

The Province passed legislation and undertook certain steps intended to cause a transition from a power industry dominated by vertically integrated, regulated utilities to one where customer choice and competition would determine new generation capacity, the price of electric energy, and retail suppliers. Alberta was the first Canadian jurisdiction to implement a restructured electrical power market. [ 19 ] Mr. Mulligan explained that electricity generation and the retail sale of electricity to end-user customers was, with small exceptions, deregulated.

The intervening links in the system, transmission of electricity (through substations and high voltage lines) and distribution (transporting electricity between main transmission wires and local users through lower voltage distribution systems) remain regulated. [ 20 ] The deregulation process sought to balance the need to provide fair returns on investments made by the regulated utilities under the previous regulatory environment. A number of generation plants had been built and funded by ratepayers before deregulation and continued to produce electricity at the time of deregulation.

The power generated by those plants was auctioned off in a power purchase arrangement or “PPA” auction in August 2000 (followed by a second auction for power that did not sell initially). The Province determined the form and content of the PPAs and issued a regulation. [ 21 ] PPA owners acquired the right to purchase electricity from a specified generating unit for amounts determined in the PPA, designed to reflect costs.

Terms range from three to twenty years, based on the lesser of the deemed remaining useful life of the generating unit or twenty years. [ 22 ] PPA owners have the right to dispatch the associated generating unit or units and sell the electric energy generated, including determining how much electricity to offer to sell into the power pool and the price at which to offer that electricity. In exchange, the PPA owner must make payments to the owner of the generating unit, based on formulas intended to compensate for variable and fixed costs.

New generating capacity developed after January 1, 1996 was subject to market forces rather than rate regulation and independent power producers were allowed into the marketplace. [ 23 ] With respect to transmission, access to the provincial transmission grid was opened to allow all eligible persons to trade energy through the power pool. Power has been traded through the power pool since 1996. The power pool is a clearing house or exchange for buyers and sellers of electricity in the province. Virtually all electricity transactions are done through the power pool.

[ 24 ] The power pool is currently operated by AESO. AESO directs which plants are to produce electricity at any given point in time to match supply with demand perfectly.

Power is dispatched in accordance with a merit order determined by AESO based upon offers by suppliers of power and bids from purchasers of power. (Lower offers are accepted first, until sufficient offers to meet demand have been accepted.) Thus, generators sell into the power pool and retailers purchase power through the power pool and arrange for distribution and the sale of electricity and other services to their customers. [ 25 ] Transmission and distribution services are paid through tariffs set by the Alberta Energy and Utilities Board (the “AEUB”, since replaced by the Alberta Utilities Commission, the “AUC”).

All persons eligible to trade power through the power pool were given open access to the grid. The grid remains a natural monopoly and continues to be regulated by the AUC. [ 26 ] Deregulation of the retail sale of electricity came into effect on January 1, 2001, affecting all of Alberta except Medicine Hat, which opted out. Smaller consumers (residential, farm, irrigation and small commercial and industrial customers) had access to transitional rates for a period up to five years.

The transitional scheme was designed so consumers could see how the electricity marketplace developed before signing a competitive offer with a retailer. Further regulations were implemented for transitional rates beginning July 1, 2006. These transition rates were determined through a combination of monthly and long-term energy pricing. [ 27 ] Before deregulation, the City of Calgary purchased electricity from generators and then sold it to consumers, with a markup for distribution and billing costs.

It provided so-called “wire services” – transmission and distribution in the Calgary area through a City department. ENMAX Corp. was incorporated in July 1997 to carry on the electric utility transmission, distribution and retail operations previously provided by the City. It was designed to facilitate the City’s participation in the competitive electricity market then undergoing restructuring.

It is wholly owned by the City of Calgary and it is governed by an independent board of directors. [ 28 ] ENMAX Corp. carries out most of its business through ENMAX Power Corporation (“ENMAX Power”), which operates the transmission and distribution systems. It owns, operates and maintains distribution networks and part of the transmission network providing power to the Calgary area. It is known a “wires services provider.” ENMAX Power operates in a regulated environment.

The AUC regulates the prices it can charge to ensure a reasonable return. [ 29 ] ENMAX Energy is a wholly-owned subsidiary of ENMAX Corp. established to carry out the energy supply and retail service functions; it arranges for the supply of electricity into the power pool and the sale from the power pool of electricity to its customers. It offers these services to residential and business customers across Alberta.

It manages a supply portfolio (including its subsidiary, ENMAX PSA) to ensure a secure and stable supply of electricity. [ 30 ] ENMAX Energy has been the default supplier of electricity for the Calgary area and the provider of transitional regulated rates for the Calgary area.

As permitted under the Electric Utilities Act , ENMAX Power contracted with ENMAX Energy to fulfill these quasi-regulated roles for customers in the Calgary area. [ 31 ] ENMAX Energy is also (by contract with ENMAX Power) the “supplier of last resort” for customers in the Calgary area unable to obtain regular electricity services from any other retailer. Further, it has signed agreements with a number of other municipalities in southern Alberta to provide transitional rate electricity and to act as default supplier. [ 32 ] In 2004, 2006 and 2007, ENMAX Energy had three classes of customers.

Some customers purchased electricity by contract with the retailer, typically at fixed prices. Others paid a regulated rate, at a price established by the AEUB during the transition period to allow customers to purchase electricity at a regulated rate while evaluating competitive alternatives. Finally, some customers paid the default rates available to those in the service providers’ area who were not party to a contract, or eligible for a regulated rate, or consumed more than a certain quantity of electricity (the rates were based on the spot rate of the power pool).

The default rate was filed with the AEUB, but not approved by it. [ 33 ] ENMAX Energy’s supply portfolio includes the Keephills PPA, which came into effect January 1, 2001 for a twenty year term, and until 2003, the Wabamun PPA. ENMAX PSA was incorporated on May 5, 2006, to acquire the Battle River PPA. It is wholly owned by ENMAX Energy, and thus indirectly by ENMAX Corp. To facilitate the purchase of the Battle River PPA, ENMAX Corp. provided a guarantee to EPCOR and to Alberta Power.

The Battle River PPA is the only revenue-generating asset acquired by ENMAX PSA. [ 34 ] As explained earlier, PPAs give buyers the right to purchase electricity from a particular generating unit from the owner of the unit, for amounts determined on a cost-based formula, intended to compensate the owner for variable and fixed costs. [ 35 ] The subsidiaries, particularly ENMAX Energy, make significant contributions to ENMAX Corp.’s bottom line. Vertical integration is one of the means by which the ENMAX group minimizes risk and addresses differences in volatilities among the various aspects of the business.

If ENMAX Corp. were to consider divesting its unregulated operations, it would have to consider a broad range of factors, such as corporate reputation and contractual obligations. [ 36 ] ENMAX Corp. has $100 million in credit facilities available to its subsidiaries for counterparties who request a letter of credit to support a transaction.

ENMAX Corp. provided letters of credit and guarantees regarding the obligations undertaken by ENMAX Energy when it purchased its PPAs, and similar obligations undertaken by ENMAX PSA in acquiring the Battle River PPA. [ 37 ] In 2004, ENMAX Energy had 37% of the residential and small commercial market by volume and 22% of the commercial and industrial market. The largest other electricity retailer was EPCOR, not really a competitor because of its concentration on the Edmonton area market. Direct Energy, in Mr. Mulligan’s view, would have been ENMAX Energy’s only significant competitor in 2004.

That year, ENMAX Energy’s revenues were 73% of ENMAX Corp.’s revenues; the comparable figure for net earnings is 72%. [ 38 ] In September 2004, ENMAX Corp.’s Treasury Group conducted an analysis and made recommendations regarding the capital structure of ENMAX Corp. and its subsidiaries. After considering a number of factors, such as the peer group of Canadian and American utilities and guidelines issued by credit rating agencies, it recommended that ENMAX Energy have a structure of 45% debt and 55% equity. Ultimately, ENMAX Corp. determined that ENMAX Energy should take on a $497 million debt to ENMAX Corp.

[ 39 ] ENMAX Energy borrowed $497 million from ENMAX Corp. pursuant to an intercompany unsecured subordinated note dated December 1, 2004, due December 1, 2014, at an interest rate of 11.5% per annum. The interest rate was established at 11.5% for reasons given in an “Intercompany Debt Pricing Memorandum” dated January 31, 2005. As a result of the amount and interest rate of the debt, ENMAX Energy took on a 91% debt to equity ratio.

In its PILOT tax returns for each of the years at issue, the 11.5% interest payments were deducted. [ 40 ] The Electric Utilities Act applied the PILOT concept to entities that were not subject to tax pursuant to the federal or provincial tax statutes. In general terms, the PILOT payments were equal to the tax that would be imposed if those entities were not tax exempt. [ 41 ] Mr. Mulligan confirmed that, as the Treasury Group had noted, this resulted in a significant tax shield; thin capitalization rules that would apply to cross-border parent-subsidiary arrangements did not apply.

Further, he acknowledged that he was unaware of any reason the debt to equity ratio would have been changed, other than tax considerations.

Further, he acknowledged that the interest rate on this intercompany loan compared with an interest rate of 5.777% ENMAX Energy had used in an application to the AEUB for carrying costs approval. [ 42 ] One of the consequences of the intercompany debt arrangements was that ENMAX Corp.’s interest costs went down drastically in its 2005 financial reports. [ 43 ] Subsequent intercompany debt was arranged between ENMAX Corp. and ENMAX PSA: $309 million at 10.3% per annum under an unsecured subordinated note dated June 5, 2006, due June 30, 2016.

The proceeds were used to acquire the initial portion of ENMAX PSA’s interest in the Battle River PPA. In its PILOT tax returns, ENMAX PSA deducted the 10.3% interest payments. [ 44 ] ENMAX PSA later borrowed an additional $58.8 million at an interest rate of 9.9% per annum, under an unsecured subordinated note dated January 15, 2007, due December 31, 2017. The proceeds were used to acquire additional ownership in the Battle River PPA.

ENMAX PSA deducted the 9.9% interest payments in its PILOT tax return for the year at issue. [ 45 ] When the first of the ENMAX PSA unsecured subordinated notes was arranged, it was recognized that the effect of the arrangement would require a second loan shortly thereafter. When that became necessary sooner than expected, ENMAX Corp. had to waive the financial covenants it had in place to do the refinancing. This 2007 borrowing caused ENMAX PSA to violate its debt coverage covenants under the 2006 note.

Thus, ENMAX Corp. provided ENMAX PSA with a waiver notice, increasing its debt coverage ratio limits. [ 46 ] The ENMAX group prepares its financial statements on a consolidated basis. Thus, everything flows up from the subsidiaries to ENMAX Corp. The practice was for ENMAX Corp. to sweep all excess cash from the subsidiaries into itself, which would impact liquidity in the subsidiaries. It could also push cash down to subsidiaries to acquire assets, if it chose. As Mr. Mulligan said, it was entirely up to ENMAX Corp. to decide what to do with any excess cash anywhere in the ENMAX Group. C.

Credit Ratings and the Pricing of Debt [ 47 ] The internal processes followed by ENMAX in determining an interest rate for intercompany debt and the analysis undertaken and opinions given by experts for ENMAX and the Crown all depended heavily on establishing credit ratings and, based upon those credit ratings, “pricing” (or setting the interest rate for) the debt. Thus, a brief overview of credit ratings and debt pricing processes is important background for the issues in this case. [ 48 ] There are a number of credit rating agencies recognized by securities exchange commissions.

A credit rating is an independent opinion, published by one of these agencies, regarding the credit worthiness of a debtor business, put into a relative scale for comparative purposes.

They are forward-looking estimates of risk reflecting the likelihood of a debtor not being able to meet its obligations as they become due, as well as the expected degree of recovery in the event of default. [ 49 ] Agencies assign credit ratings to issuers (the company issuing the bond, that is, the borrower) and the issue (the specific loan or bond being used to raise funds). [ 50 ] The Standard and Poor’s rating scale was most commonly used in this trial, although the parties made frequent reference to the Moody’s scale as well. (Levels on these two scales are identical, for present purposes, although the letter designations are different.) [ 51 ] The following is Standard & Poor’s rating scale, ranging from the most credit worthy at the top, to the least credit worthy at the bottom: AAA AA+ AA A+ A A-

BBB+ BBB Investment Grade BBB- Non-Investment Grade, High Yield or BB+ Speculative Grade BB BB- B+ B B- CCC+ CCC CCC- CC [ 52 ] Rating agencies do not categorize ratings as investment or speculative grade, but it has been common in the market place to use these designations. For example, some investment portfolios are restricted to investment grade bonds, while others strictly limit the amount of speculative grade bonds that may be held in a portfolio. [ 53 ] Credit ratings are a significant determinant of a bond’s interest rate.

In general, the “face value” of a bond is the amount lent by the bond holders to the issuer (the loan principal). The annual “coupon” amount, in dollars, is the coupon rate in percentage times the face value of the bond. [ 54 ] The value of a bond is the present value of its expected coupon and principal payments, discounted using interest rates reflecting the perceived risks associated with the bond. Often, at issuance the coupon rate is equal to market interest rates, thus the selling price of the bond will be equal to its face value.

Over time, a bond will sell at a premium to its face value (the market interest rate then being lower than the coupon rate), or at a discount to its face value (the market interest rate then being higher than the coupon rate). [ 55 ] Bonds often trade on the secondary market after initial issuance. The level at which a bond is trading reflects a variety of factors, including the general level of interest rates or changes in the issuer’s credit rating. When a bond’s price is no longer equal to its face value, the coupon rate no longer accurately reflects the return earned by a bond investor.

Instead, the relevant measure of the bond’s return is “yield to maturity,” which combines the coupon rate and the difference between the face value of the bond and its market value as the measure of the annual return that an investor would get by buying the bond. [ 56 ] To estimate the market interest rate for a new bond, consideration will be given to market yields to maturity and coupon rates for comparable outstanding bonds, as well as coupon rates on recent newly-issued bonds. In determining comparables, it is important to find finding credit ratings similar to the bond for which a rate is being estimated. D.

ENMAX Pricing Documents 1. Introduction [ 57 ] Each of the intercompany notes has a corresponding “Inter-Company Debt Pricing Memorandum” that sets out the borrower’s explanation and justification for the reasonableness of the interest payable under each note. While the memoranda do not say so expressly, I infer that these documents were prepared to defend the interest deductions to the Crown. No other purpose has been suggested. [ 58 ] Mr.

Mulligan was not involved in the process leading up to the debt transactions or the preparation of the pricing memoranda, but he testified that the memoranda memorialized the process and conclusions regarding ENMAX’s process. Further, as ENMAX’s witness he explained the process that was followed and also was questioned on these matters by the Crown. Experts for ENMAX and the Crown based part of their analysis and took some assumptions from these memoranda.

It is therefore useful to briefly review the processes these documents describe. 2. 2004 Intercompany Note [ 59 ] The pricing memorandum for the 2004 note records that the recapitalization of subsidiary companies and the introduction of intercompany long term debt financing “is part of a strategy to establish the parent ENMAX Corporation as the source of internal funding and external financing (the investment vehicle for its subsidiaries), to align the corporate structure with the focus of the

organization and to better utilize surplus funds.” It refers to the debt to equity ratio put into place and explains that “this memorandum deals primarily with the reasonable rate of interest for this debt issue and includes details of the research and analysis that was performed to determine this rate.” [ 60 ] The memorandum sets out an analysis of the subordination and conditions of the debt, in particular identifying important financial covenants regarding the relationship between debt and interest obligations to various measures of the company’s earnings. [ 61 ] Next, the memorandum contains detailed financial forecasts for the next five years and analysis based on key financial ratios.

Both parties’ experts adopted these financial forecasts in developing their opinions. A range of interest rates from 8% to 13% were used as sensitivity tests, to ensure a reasonable expectation of earning cumulative profits in future years. The memorandum then calculates key financial ratios used by Standard & Poor’s in determining debt ratings. [ 62 ] Based on its own assessment of comparables and fundamentals and on conversations with ENMAX Corp.’s analyst at Standard & Poor’s, ENMAX Energy determined its business profile to be 7 (on a scale of 1, strong, to 10, weak).

With this in hand, Standard & Poor’s methodology was used to establish a credit rating, based on a range of factors such as debt coverage ratios. Then, after considering Standard & Poor’s methodology in notching down credit ratings for subordinated debt and other market evidence, the memorandum concluded that “EEC’s notional debt rating using S & P criteria is in a range of from ‘CCC’ to ‘B’.” [ 63 ] The pricing memorandum also addressed the total amount of the debt.

ENMAX Energy analysed various debt coverage multiples and compared the amount of debt to industry comparables, in conjunction with CIBC World Markets, Debt Capital Markets. It concluded that “by all measures of debt capacity analysed by ENMAX the $497 million level of debt .... is less than industry comparables for companies with credit ratings, financial ratios and multiples similar to those of EEC. The overall average of these measures is $613 million.

On that basis, ENMAX has concluded that debt sized at $497 million is reasonable by financial industry standards.” [ 64 ] In determining the interest rate, ENMAX Energy looked at other companies that issued intercompany debt and companies that issued non-investment grade debt in private markets and public debt capital financial markets for non-investment grade debt.

Due to lack of adequate data for non-investment grade trades in Canada, Canadian comparables were primarily based on intercompany borrowings made by EPCOR (another government-owned utility) and by energy and business trusts. [ 65 ] The various forms of analysis generated comparables in a range from 10.5% to 13.5%.

Having regard to the fact that 11.5% would provide a reasonable expectation of profit (based on the earlier financial projections), ENMAX Energy concluded that 11.5% would be a reasonable interest rate for the 2004 note. 3. 2006 Intercompany Note [ 66 ] The pricing memorandum for the 2006 note explains that ENMAX PSA was incorporated to acquire the Battle River PPA, with the 2006 intercompany loan of $309 million funding about 90% of the purchase price.

The balance would be partly funded from an expected strong cash flow generated by ENMAX PSA, but it was anticipated there would be a need for additional financing from ENMAX Corp. [ 67 ] The memorandum sets out an analysis similar to that for the 2004 intercompany note, but briefer in detail. It explains the preparation of a financial analysis, with cash flows predicted to be strong over the first five years but then declining. (Both parties’ experts accepted and relied upon this forecast as well.) A number of ratios were used.

The result of the financial analysis was a notional debt rating of CCC. [ 68 ] The amount of debt was considered to be well within the maximum range of the various debt coverage ratios obtained from internal research and RBC Capital Markets. The memorandum then analysed data available from public debt markets, combined with advice from CIBC.

In the result, based on methodology adopted from Standard & Poor’s, its internal research and data, and advice from CIBC, the memorandum concluded that the debt should be priced at an interest rate of 10.3% per annum. 4. 2007 Intercompany Note [ 69 ] For the January 4, 2007 intercompany note, the pricing memorandum referred again to the background of ENMAX PSA’s incorporation as a vehicle to acquire the Battle River PPA. [ 70 ] The memorandum stated that the 2006 financial results showed weaker debt coverage than expected but a current forecast showed improving cash flow over the next five years, partly due to forecasted price increases.

The memorandum anticipated longer term deterioration in cash flow (after five years), since prices were expected to decline and units would be decommissioned. It was noted that the debt/capitalization ratio would, in the near future, result in an increase beyond the level permitted under the 2006 intercompany note covenants, but “robust” cash flow was expected to bring the ratio back into line by the end of fiscal 2007.

On that basis, the additional debt of $58.8 million to be assumed on January 15, 2007 was considered acceptable. [ 71 ] As with the forecasts in the earlier pricing memoranda, the Crown’s expert accepted this optimistic financial forecast, but ENMAX’s expert rejected it as unfounded. [ 72 ] With the application of Standard & Poor’s metrics, ENMAX PSA considered it appropriate to maintain the notional credit rating of CCC. Market comparables were used to establish an appropriate interest rate, with data surveyed through Bloomberg. It was determined that 9.9% was an appropriate interest rate. E.

Questions for Determination

[73] The fundamental issue to be resolved is whether the interest paid by ENMAX Energy and ENMAX PSA on the threeintercompany notes is a “reasonable amount” such that it is deductible pursuant to section 20(1)(

c) of the Income Tax Act, R.S.C. 1985,c. 1 (5th Supp.). [74] Importantly, the Crown says this question must be resolved in the context of the regulatory scheme established under theElectric Utilities Act by which the provisions of the Income Tax Act are adopted.

In other words, it submits that application of the IncomeTax Act may have a different result in this case than it would if the dispute were to be determined solely as a matter of federal income taxlaw. [75] ENMAX Energy and ENMAX PSA, however, submit that the question must be determined solely on the basis of federalincome tax legislative provisions and cases considering them. The fact that these provisions have been incorporated into a provincialregulatory scheme should not affect their

interpretation and application. III Principles of Law A. Statutory Framework [76] ENMAX Energy and ENMAX PSA are government-owned participants in the Alberta electric industry, because their parentis owned by the City of Calgary. Thus, they are not taxpayers. [77] The Payment in Lieu of Tax Regulation, Alta. Reg. 112/2003, as amended (“PILOT Reg.”) made pursuant to the ElectricUtilities Act, requires payments to the balancing pool equal to what would have been payable under the Income Tax Act and the AlbertaCorporate Tax Act, R.S.A. 2000, c. A-15, as if the company was not exempt from taxation under those statutes: PILOT Reg.,

section 2. [78]

Section 12 of the PILOT Reg. provides that Alberta’s Minister of Finance may take the actions authorized by and is subject tothe obligations imposed by the federal and provincial tax statutes. Also, the entities subject to the PILOT Reg. are entitled to the rights,processes, procedures and remedies available to taxpayers and are subject to the obligations of taxpayers under the same statutes. Section12(3) states that a decision of the minister that would be subject to appeal to a court under the tax statutes may be appealed to the Courtof Queen’s Bench of Alberta. B.

The Assessments and Appeals [79] The Crown reassessed the PILOT tax returns for the years in issue on the basis that the rates and amounts of interest payableunder the intercompany notes were unreasonable. The reassessments set the reasonable rates of interest at 5.42% for the 2004 note,5.26% for the 2006 intercompany note and 5.24% for the 2007 note. [80] Pursuant to

section 48 of the Alberta Corporate Tax Act, ENMAX Energy and ENMAX PSA served notices of objection tothe assessments. They subsequently commenced an appeal under

section 50 of that statute which, by sections 52 (1) and 1(2)(c), isdeemed to be an action in the Court of Queen’s Bench. [81] This appeal involves one issue under the Income Tax Act, namely whether ENMAX Energy and ENMAX PSA are entitled todeduct the interest paid to ENMAX Corporation under the three intercompany notes. The availability of that deduction is governed bysection 20(1)(c), which provides in its relevant parts as follows: 20(1) ....[In] computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of thefollowing amounts .... .... (

c) interest -- an amount paid in the year or payable in respect of the year .... pursuant to a legal obligation to pay interest on .... (

i) borrowed money used for the purpose of earning income from a business or property .... .... or reasonable amount in respect thereof, whichever is the lesser[.] [82] In simpler form, McLachlin J (now C.J.C.) paraphrased the

section as providing that “the taxpayer is entitled to deduct thelesser of, (1) the actual amount paid, or (2) a reasonable amount in respect of ‘an amount paid .... pursuant to a legal obligation to payinterest on .... borrowed money used for the purpose of earning income from a business or property’ ”: Shell Canada Ltd. v. R., (SCC), [1999] 3 S.C.R. 622 at para 34, 178 D.L.R. (4th) 26. C. Statutory

Interpretation [83] The modern rule of statutory

interpretation is that “the words

an Act are to be read in their entire context and in theirgrammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament”: LudcoEnterprises Ltd. v. R., 2001 SCC 62 at para 36, [2001] 2 S.C.R. 1082, quoting Driedger, Construction of Statutes (2nd ed., 1983) at 87. [84] The Supreme Court of Canada has also set out clear guidelines for the

interpretation of the Income Tax Act. As applicable to

this appeal, I paraphrase them as follows:

a) The overall policy of Parliament that should inform construction of the Income Tax Act is that tax law be certain, predictable and fair so that taxpayers can intelligently order their affairs: Canada Trustco Mortgage Co. v. R ., 2005 SCC 54 at paras 31 , 42 & 50, [2005] 2 S.C.R. 601.

b) Courts should not look for unexpressed legislative intentions or overriding policies not anchored in a textual, contextual and purposive

interpretation of specific provisions: Ludco, para 38; Shell , para 43; Canada Trustco, para 42. Doing so risks upsetting the balance established by Parliament in a complex statute that encompasses a broad range of principles.

c) In particular, courts should not interpret the substantive provisions of the Income Tax Act based on concerns about tax avoidance, because taxpayers are fully entitled to structure their transactions in a manner that reduces taxes: Singleton v. R., 2001 SCC 61 at para 28 , [2001] 2 S.C.R. 1046; Ludco , para 39; Shell , para 44 to 46; and Canada Trustco, para 31. Achieving the various policies promoted in the Income Tax Act depends on taxpayers taking full advantage of its provisions: Canada Trustco, para 31: TDL Group Co. v. Canada , 2016 FCA 67 at para 22 . D. Effect of PILOT Reg. [ 85 ] The Crown submits that government policy in deregulating the electrical power market must inform the

interpretation of section 20(1) (

c) of the Income Tax Act , as it is applied within the PILOT Reg . It relies on one of the purposes of the Electric Utilities Act as being “to establish rules so that an efficient market for electricity based on fair and open competition can develop in which neither the market nor the structure of the Alberta electric industry is distorted by unfair advantages of government-owned participants”:

section 6(c). Thus, the Crown submits that a “reasonable amount” must take into account whether the interest deduction creates an unfair advantage to ENMAX Energy and ENMAX PSA. In oral submissions, the Crown acknowledged that its position meant that the same transaction could give rise to different results under section 20(1)(

c) of the Income Tax Act , depending on whether it was being applied by a government-owned entity or an entity taxable in the usual course. [ 86 ] The Crown particularly emphasized “leveling the playing field” among the various types of entities in the electricity industry. It referred to the following passage from the legislative debates: ....[I]f a municipality decides to compete in [the electricity] sector, it must play by the same rules as everybody else. It should not have any unfair advantages when competing with the private companies.

This ensures a level playing field, and it’s in the best interest of the consumers.... .... Now, private sector companies pay taxes, but municipalities do not. You can’t achieve a level playing field if you have tax-free municipal affiliates competing with taxpaying private sector companies. Bill 27 addresses this discrepancy by requiring that municipalities make payments in lieu of taxes if they set up an affiliate competing with the private sector in the retail electric market.... [Alberta, Legislative Assembly, Hansard , 24 th Leg, 2nd Sess (31 March 1998) at 1265 (Dr.

West.] [ 87 ] I am not persuaded by the Crown’s argument. In my view, section 20(1) (

c) of the Income Tax Act has the same meaning when applied under the Electric Utilities Act as when construed in the context of taxable private entities. It may be that government policy, particularly in the PILOT scheme, is to level the playing field. The legislature has implemented that policy by requiring government- owned entities to make payment in lieu of taxes. That point comes out clearly in the speech from Dr. West in the Hansard passage on which the Crown relies (although such references are of doubtful guidance in statutory

interpretations). [ 88 ] There is no basis for the Crown or the court to impose further obligations motivated by a desire to level the playing field. Doing so would undermine the interpretive principles governing taxing statutes, as set out earlier. Those principles, in my view, apply to the PILOT Reg . as well. It is clearly intended to be a form of taxing statute, and expressly gives the minister and the municipal entity the same entitlements and obligations they would have under the Income Tax Act : PILOT Reg., sections 12(1) and (2) .

Further, it would be anomalous to find that Alberta’s legislature intended to incorporate the words of the Income Tax Act , but not the jurisprudence considering it. [ 89 ] Nor does TransAlta Corporation v R ., 2012 FCA 20 , 426 N.P.R. 27, assist the Crown. In applying the “ Gabco test ” (to which I will turn later) the court notes that in construing what a reasonable business person would do, “long-standing regulatory and industry practices, as well as auditing and valuation standards and practices , are relevant” (para 75).

This merely means that the taxpayer’s “business considerations”, on which the Gabco test focuses, must be the context for determining what is reasonable. That is, the type of business in which the taxpayer operates, including its regulatory, commercial and fiscal aspects, is important context for any reasonableness assessment. What would be reasonable for a business in the retail industry to pay may not be the same as for a business in the electrical utilities sector. E.

ENMAX’s Pricing Process [ 90 ] The evidence shows that the PILOT tax considerations were primary considerations in structuring the intercompany debts, particularly since the amount of debt significantly increased the debt to equity ratio beyond the recommendations made by ENMAX Corp.’s Treasury Group in September 2004. [ 91 ] The Treasury Group recognized that, all other things being equal, greater debt gave a larger tax shield and from that perspective it made sense to “lever the taxable organizations up,” while recognizing that all tax planning is subject to reasonability tests.

The same considerations applied to the interest rate, although that issue was not addressed by the Treasury Group in its recommendations on capital structure. Mr. Mulligan acknowledged that he was unaware of any reason the debt to equity ratio would have changed from

the Treasury Group’s recommendations, other than tax considerations. [ 92 ] Neither the Income Tax Act nor the PILOT Reg. gives taxpayers a detailed test against which to measure their transactions for reasonableness. Thus, management must make its own decisions, recognizing that the Crown may challenge these choices. [ 93 ] The parties differ on how much weight should be given to ENMAX’s pricing of the debt, as set out in the pricing memoranda. ENMAX argues that the court should defer to the exercise of management’s business judgment unless it concludes that the rate chosen is unreasonable.

It argues that an important part of the analysis should be whether management’s process was reasonable in all of the circumstances. If the decision was made in a considered way, asking the appropriate questions and taking reasonable steps to answer them, then a high degree of deference should be shown to the decisions resulting from the process. [ 94 ] The Crown, on the other hand, effectively says that ENMAX’s “due diligence” is irrelevant. There can be no deference.

If a taxpayer deducts an amount, the Crown is entitled to question whether the amount is reasonable, and if it is not, determine what a reasonable amount would be. The steps taken to justify the amount are immaterial. [ 95 ] It overstates the law to suggest that the borrowers’ explanations and justifications in this case (contained in the pricing memoranda) have no value. The Supreme Court of Canada has emphasized that making transactions and structuring them to avoid or minimize tax is not against tax policy.

Further, given that the test for reasonableness must be measured with reference to the legal obligation under which interest is paid ( Shell , para 28, for example) and having only the taxpayers business considerations in mind ( Gabco , para 52) a taxpayer’s explanation for the amount of interest it seeks to deduct is of great import. [ 96 ] I agree that section 20(1) (

c) of the Income Tax Act requires a reasonable amount, not a reasonable process. But the process followed by the taxpayer and its explanations cannot be disregarded. They inform the Crown and the court of the transaction to be measured and the taxpayer’s business considerations. To disregard this information would be an error in applying section 20(1)(c). F. “Reasonable” Amount of Interest Deduction 1. General Principles [ 97 ] Under section 20(1)(c), a taxpayer is entitled to deduct only a reasonable amount of interest paid pursuant to a legal obligation on borrowed money used to earn income.

The court in Shell identified four elements at para 28: The provision has four elements: (1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable, as assessed by reference to the first three requirements. The Crown agrees that the first three elements are satisfied.

Thus, the only dispute is whether the amounted deducted by the ENMAX companies was reasonable. [ 98 ] For the purposes of this case, I derive from the authorities three broad considerations that govern the determination of what is reasonable. 2. Transaction to be Assessed [ 99 ] Reasonableness must be measured with reference to the legal transaction to which the borrower was a party, not other contracts it might have made.

The four-element test itself makes this clear by requiring that reasonableness be assessed by reference to the first three elements of the test, one of which is that the interest must be paid pursuant to a legal obligation. Thus, that legal obligation, not another possible one, is the reference point. [ 100 ] The need to focus on the borrower’s actual legal transaction is also clear from how the court dealt with the facts in Shell . The taxpayer wanted US dollar financing, which it could have borrowed directly at market rates of 9.1% interest.

Instead, it borrowed New Zealand dollars at 15.4% interest and exchanged those funds for US funds, and made a number of ancillary arrangements as part of these transactions.

The effect of these transactions was to increase the deductible interest expense and ultimately obtain a lower after-tax cost of financing than if it had borrowed US funds directly. [ 101 ] The Federal Court of Appeal reduced the interest deduction to 9.1%, holding, among other things, that 15.4% interest was not reasonable when US funds could have been borrowed directly at 9.1%. [ 102 ] The Supreme Court of Canada rejected that conclusion and the minister’s arguments to the same effect.

McLachlin J. (now C.J.C.), writing for the court, was concerned about a wide examination into the economic realities of the taxpayer’s situation, holding that “recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect”: paras 38 and 39.

She held that Shell’s legal relationship with the foreign lenders came within the criteria of deducting a reasonable amount of interest on borrowed money used for the purpose of earning eligible income, and it was therefore entitled to the deduction based on the higher interest rate. [ 103 ] The Crown relies upon Shell for a different purpose. It argues that the amount paid for the New Zealand funds was deductible because “where an interest rate is established in a market of lenders and borrowers acting at arm’s length from each other, it is generally a reasonable rate” ( Shell , para 34).

It suggests, based on business management theory that (in the Crown’s words) “the appropriate price for an intercompany loan is the market price – the price that unrelated third parties would charge.” [ 104 ] There are two problems with this argument. First, Shell does not hold that an arm’s length market price determines what is reasonable, but (especially when it is higher than the taxing authority proposes) it is a strong indication of reasonableness. Second, Shell

does not support holding one transaction to a market standard derived from another transaction. Its finding on the facts indicates that suchan approach is an error of law. [105] The importance of focusing on the borrower’s actual transaction is also evident, although less analogous on the facts, inSingleton. The taxpayer was a partner in a law firm. He used funds paid to him from his capital account with the firm to purchase a homeregistered in his spouse’s name. On the same day, he borrowed money from a bank and paid the funds back into his capital account.

Hethen deducted the interest payments made on the bank loan against the income he earned from the firm. [106] The issue in that case was whether the third element of the Shell test, namely that the borrowed money must be used for thepurpose of earning income, was satisfied.

The tax court found that the purpose of the money was to purchase a house and this could notbe altered by the “shuffle of cheques”: Singleton, para 32. [107] At the Supreme Court of Canada, Major J., for the majority, agreed with the taxpayer’s position. “It is this ‘shuffle of cheques,’” he wrote, “that defines the legal relationship which must be given effect”: para 32. It was an error to treat the arrangements as onetransaction, when the taxpayer used the borrowed funds for the purpose of refinancing his partnership capital account with debt – thelegal transaction to which the court must give effect: para 34.

The Federal Court of Appeal recently applied these principles in TDLGroup at para 25, reaffirming that “the reasonableness must be assessed by reference to the terms upon which the monies were lent andthe purpose for which the borrower used the money”. 3. Arm’s Length Comparators [108] The interest that would have been paid in an arm’s length transaction may be a relevant factor, but it does not define what isreasonable.

The question is whether the amount paid was reasonable from the borrower’s perspective in the subject transaction: HuskyEnergy Inc. v Alberta, 2012 ABCA 231 at paras 44 and 46, 533 A.R. 385. [109] In Shell, the taxpayer needed access to US funds that it could have obtained directly at 9.1%.

Nonetheless, it was reasonable fordeductibility purposes to acquire those funds through a New Zealand lender at 15.4%. [110] The Federal Court of Appeal acknowledged when considering whether deductions were reasonable for purposes of anothersection of the Income Tax Act that paying fair market value for something is prima facie reasonable, but it does not necessarily followthat paying more than fair market value is unreasonable. “There may be circumstances in which a decision to pay more than fair marketvalue for something is a reasonable decision”: Petro-Canada v.

R., 2004 FCA 158 at para 64, 319 N.R. 261. [111] The Crown has submitted that the test should include an arm’s length criterion, referring to Morgan v R., 2007 TCC 475, 2007CCI 475. In considering a deduction under section 8(1)(

i) for “amounts as may reasonably be regarded as applicable .... to salary” under acontract of employment, in this case the wife of the taxpayer, the court approvingly quoted the Gabco test. In applying the test to thefacts, Bowie J. held “I am of the view that no reasonable business person in an arm’s length relationship would have agreed to thebillings that Mr. Morgan paid”: para 14. [112] At best, the case is weak authority for adopting such a significant qualification to the Gabco test.

It contains no explanation forwhy the test was modified when it was applied to the facts, although perhaps only an arm’s length benchmark could establishreasonableness in that case. For the reasons already given, I conclude the reasonableness standard set out in section 20(1)(

c) cannotgenerally be based on an arm’s length standard. Doing so would go against the entire tenor of the Supreme Court of Canadajurisprudence. [113] It is noteworthy that the Income Tax Act expressly imposes an arm’s length standard, rather than a simple reasonablenessstandard, in other contexts. For example, section 247(2) (formerly section 69(2)) applies to transfers of property or services betweenrelated corporations across national boundaries.

This “transfer pricing” provision limits deductions to amounts that would have beenreasonable if the parties had been dealing at arm’s length: see, for example, GlaxoSmithKline Inc. v R., 2012 SCC 52, at paras 1, 19 and35, [2012] 3 S.C.R. 3. This reinforces the conclusion that reasonableness is not defined based on arm’s length comparators alone. 4.

Range of Reasonableness [114] The standard of reasonableness does not require that a taxpayer’s deduction be ascertainable as a precise, correct amount.Rather, it allows a range of amounts to be considered reasonable. [115] A general description of how to determine reasonableness was given in Gabco Ltd. v. Minister of National Revenue, (CA EXC), [1968] 2 Ex. C.R. 511, 68 D.T.C 5210 (Ex. C.C).

Gabco considered whether a family business’ payments to afamily member and shareholder were reasonable. “It is not a question of the Minister or this Court substituting its judgment for what is areasonable amount to pay,” said Cattanach J., “but rather a case of the Minister or the Court coming to the conclusion that no reasonablebusiness man would have contracted to pay such an amount having only the business consideration of the appellant in mind”: para 52. [116] This test has been adopted and applied by the Tax Court of Canada and the Federal Court of Appeal (the latter in Petro-Canada), although not by any authorities binding on this court.

In my view, it is a helpful statement of what is meant by “reasonable” insection 20(1)(c). [117] The Gabco test adopts the perspective of the borrower’s business considerations, which is consistent with the other principles Iidentified earlier. Thus, it refers to a particular set of circumstances, including the actual legal arrangement establishing the interestobligation. It does not make it impossible for taxing authorities to challenge a deduction, because it limits deductibility to the amountsreasonable business persons would contract to pay. Its phraseology infers, however, that there will usually be a range.

G. Burdens of Proof

[118] For reasons set out earlier, the PILOT regime is intended to operate as a tax regime. Unless expressly stated in the legislationand regulations, it should be treated as such by the Crown and the courts. It is the mechanism the legislature chose to level the playingfield between government and non-government entities in the electrical utilities sector. [119] There are particular rules regarding the burden or onus of proof in tax cases. They were established as a matter of thesubstantive law of taxation, without reference to rules of court: Johnston v.

Minister of National Revenue, (SCC), [1948]S.C.R. 486 at paras 7 to 9, [1948] 4 W.L.R. 321; Bayridge Estates Ltd. v. Minister of National Revenue, (CA EXC),[1959] Ex. C.R. 248 at para 7, 59 D.T.C 1098 (Ex. C.C.). They are codified in some statutes, but that does not change the fact that theyare based on the substantive law of their subject matter, a common occurrence with many burdens of proof found throughout our legalsystem: Sopinka, Lederman and Bryant, The Law of Evidence in Canada, 4th ed. (Markham, Ont: LexisNexis, 2014) at para 3.1. [120] The burden of proof, summarized in Hickman Motors Ltd. v.

R., (SCC), [1997] 2 S.C.R. 336 at paras 92-95,148 D.L.R. (4th) 1, is the civil balance of probabilities, borne by the taxpayer, as appellant from an assessment: Johnston, para 9; Trac v.British Columbia, 2007 BCCA 60 at paras 25 & 32, 61 B.C.L.R. (4th) 359. [121] The taxpayer also has an initial onus of adducing a prima facie case disproving the facts assumed by the Crown in determiningthe tax said to be owing. This burden applies only to the exact assumptions made by the minister: Hickman Motors, para 92.

Thetaxpayer bears the burden because it has first-hand knowledge of its affairs and is in the best position to adduce relevant evidence toprove the material facts: Trac, para 25.

The taxpayer can challenge the minister’s assumed facts, showing that one or more of theassumptions was wrong, or contend that even if proved, the assumptions do not support the assessment: para 27. [122] If the taxpayer meets this primary burden of proof, the onus and standard of proof revert to the normal rules of civil procedure,with the taxpayer having the onus to prove the material facts on a balance of probabilities, and the minister of having the onus toestablish material facts to support a defence to the same civil standard, and the court weighing both parties’ evidence: para 32. [123] The burden of proof is important mainly in cases where either party fails to adduce evidence on a central point.

This case doesnot turn on the application of the burdens of proof. Both parties addressed the issues fully through agreed facts, exhibits andexaminations of witnesses. IV Evidence A. Expert Witnesses 1. Introduction [124] Both sides presented extensive expert evidence related to corporate credit ratings and the issuance and pricing of corporate debt.ENMAX put forward two expert witnesses, while the Crown presented four. 2. ENMAX witnesses a. Robert Weiss [125] ENMAX presented Mr. Robert Weiss, who was qualified as an expert on corporate credit ratings.

He has extensive experiencewith credit ratings, primarily at Standard & Poor’s, a prominent global ratings agency, and Global Capital Advisors, a consulting firmthat advises and assists clients on obtaining credit ratings or having credit ratings reviewed by credit rating agencies. [126] Mr. Weiss was retained by the plaintiffs to establish an “implied credit rating” for each of ENMAX Energy and ENMAX PSAand the intercompany notes reflecting their respective debts to ENMAX Corp.

He followed as closely as possible the approach a creditrating agency would have taken to establish credit ratings, had they been applied for, as of the dates of the three notes. [127] Mr. Weiss gave his testimony in a clear, straightforward manner. He did not avoid difficult questions and gave simple answerswhere required, regardless of whether the point tended to support his overall conclusions. Nevertheless, in my view, key points of hisanalysis are based on arbitrary assumptions and choices.

The clearest and most important of these are his use of the interest rate in theintercompany notes for his financial risk analysis, his inconsistent approach to relying or not relying on company assumptions (theinterest rates, the 2007 financial forecast), and his refusal to give any degree of effect to implicit parental support. These will bediscussed in more detail below. b. Gregory Johnson [128] Mr. Mark Nichols, the managing director and founder of Global Capital Advisors, prepared ENMAX’s expert reports onpricing the issuance of debt by ENMAX Energy and ENMAX PSA. Mr.

Gregory Johnson joined Global Capital Advisors as a managingdirector in 2013. He was previously with Bank of America for 23 years, working primarily in debt capital markets. [129] Mr. Johnson worked with Mr. Nichols (and Mr. Weiss) in the preparation of the expert reports. Mr. Nichols could not testifydue to serious illness, so with the consent of the Crown, Mr. Johnson testified on the issues addressed in Mr. Nichols’ reports.

He wasqualified as an expert in the issuance and pricing of corporate debt, and thus entitled to give opinion evidence on the pricing of debt as itrelated to the affairs of ENMAX. [130] Mr. Johnson was an impressive witness who testified in a clear, fair and straightforward manner throughout. Further, he fairlyacknowledged a number of weaknesses in Mr. Nichols’ reports and readily acknowledged when he thought Mr. Nichols had wrongly

criticized Dr. Goldreich, or when his approach seemed unsupportable. 3. Crown witnesses a. David Levey [ 131 ] Mr. David Levey taught in universities after obtaining undergraduate and graduate degrees in economics and then began working in the financial sector. From 1985 to 2004, he worked at Moody’s Investors Service as part of its credit ratings team.

His specialty was in the ratings of national governments (including Canada), sub-sovereign entities (states, provinces, regions and cities) and government-owned companies, such as Crown corporations and government-owned utility companies. [ 132 ] He was qualified as an expert on credit ratings, credit rating analysis and the credit rating process, entitled to give opinion evidence on those matters as they pertain to ENMAX. The Crown asked Mr. Levey to prepare an expert report setting out the credit ratings he would have assigned to the three notes at issue, as of their respective dates. [ 133 ] Mr.

Levey’s testimony was given with conviction and obviously based on extensive experience and knowledge of the credit rating industry. Apart from the first part of his cross-examination (which occurred near the end of his first day of testimony), he was confident and committed to his opinions throughout. Mr. Weiss and Mr. Johnson appeared, at times, as undertaking the responsibility of explaining and justifying certain opinions, and advocating positions. That is not to detract from their integrity – each of them fairly gave ground as occasion required. On the other hand, Mr.

Levey testified to an analysis and conclusions to which he remained committed throughout. He is obviously convinced of the correctness of his analysis and conclusions. [ 134 ] Furthermore, Mr. Levey’s approach is more convincing on some key points. His method of selecting the interest rate to use for financial projections is much more convincing than Mr. Weiss’s approach, which as Mr. Weiss fairly acknowledged, has an element of circularity to it. Mr. Levey’s recognition of implicit parental support is also more convincing than Mr.

Weiss’s conclusion that the subsidiaries should be viewed as completely separate organizations. This leaves aside, for the moment, the question of whether it is proper to assume implicit support when evaluating possible comparators to the ENMAX transaction. b. David Goldreich [ 135 ] Dr. David Goldreich was qualified as an expert for the Crown in the areas of corporate finance, capital markets, and the analysis of pricing of fixed income securities. [ 136 ] He is currently a professor at the Rotman School of Management, University of Toronto.

He has published extensively in peer- reviewed journals, given numerous presentations, and conducted extensive research in his fields. However, he has not worked in investment banking or on trading desks. His experience is limited to academic teaching, publishing and research. [ 137 ] In his first report, he set out to estimate the market rate of interest for the three intercompany notes had they been offered in the Canadian market place in the form of a bond between their issuers and third party buyers on their stated dates.

His analysis proceeded on the assumption that each offering had a BBB or equivalent credit rating. His general approach was to look at other bonds with similar dates and interest rates, average the results, and then make necessary statistical adjustments. [ 138 ] Dr. Goldreich was a confident, articulate witness, thoroughly grounded in his field. While his only experience is as a scholar, his evidence disclosed no weakness attributable to lack of experience working in the field. c. Bradley Wendt [ 139 ] Mr.

Bradley Wendt, another Crown witness, was qualified as an expert in the areas of bond underwriting and fixed income security pricing. He has significant industry experience in the field of investment banking. He explained that his role is often to assist clients as they follow the credit rating process, working with them in conjunction with the rating agency at every stage as necessary to obtain a credit rating.

Typically, he would work with a client to obtain two independent credit ratings, and sometimes three. [ 140 ] Ratings on bonds are crucially important, because they provide an independent opinion of the credit quality of the debt instrument. It affects the cost of capital. [ 141 ] He explained the very extensive process involved in obtaining a credit rating. An investment banker is always attempting to get the highest credit rating. There is also a natural delineation between investment grade ratings and non-investment grade ratings.

This is primarily because there is a significant number of potential buyers, particularly retail buyers, who can only buy bonds classified as investment grade. Investment grade categories are considered relatively risk free as compared to the categories below the notional line. [ 142 ] He agreed that institutional investors do their own independent research, comparing their opinion with the opinion of two or three rating agencies. However, they all work from the same source documents, and rarely is there a wide divergence.

If an investor grossly disagrees with a rating service, they just do not buy the bond. [ 143 ] Mr. Wendt presented and spoke with impressive demeanor, consistent with his background. He was confident and well-spoken but concise. I found him to be a fair and credible witness. d. Eric Powers [ 144 ] Dr. Eric Powers was qualified as a Crown expert in the areas of fixed income securities, including make-whole call provisions. He is Associate Professor of Finance at the Moore School of Business, University of South Carolina.

[ 145 ] He has extensive teaching and research experience. He has published a number of peer reviewed papers relating to make-whole call provisions and his research has required him to review hundreds of bonds with make-whole provisions. He has then analyzed, from market data, the effect make-whole provisions have on the yield-to-maturity that would be demanded by arm’s length investors. B. Expert Evidence 1. Credit rating a. Business risk and financial risk [ 146 ] Mr. Weiss and Mr. Levey each adopted a broadly similar approach to establishing credit ratings.

They first assessed the issuer’s business risk, which requires a qualitative analysis of the company and its business. Business risk analysis requires assessing the predictability of the company generating adequate cash flow to meet its obligations. Determining a rating requires looking at volatility in the company and its industry, over an entire business cycle – both good and bad times. [ 147 ] They then assessed financial risk, a quantitative analysis of the company’s financial performance, both past and as forecast.

The analysis takes into account the industry within which an issuer operates and the regulatory framework governing its business. They then considered whether implicit support could be found based on its relationship to a parent owning 100% of its shares, and finally, made adjustments for the nature of the debt, such as whether it was secured, unsecured, or subordinated. [ 148 ] Mr. Weiss considered a number of comparable companies in the course of his analysis.

For the most part, he looked at the same comparable companies for ENMAX Energy and ENMAX PSA, as he considered them both to be unregulated companies in the electricity industry. He chose all unregulated companies for comparison, notwithstanding that ENMAX Corp.’s Treasury Group used regulated companies as comparables when making recommendations on the appropriate capital structure. [ 149 ] Mr. Weiss found both issuers to have heightened business risks, with ENMAX PSA’s risk to be even higher than ENMAX Energy’s (for both 2006 and 2007).

For ENMAX Energy, he noted uncertainty and turmoil in the electric utility industry going through a period of deregulation. [ 150 ] He acknowledged, however, that the regulated rates that remained available to a large portion of customers reduced the business risk. This aspect of the business was about 42% in 2004 and projected to increase to nearly 60% by 2009. In addition, about 20% of ENMAX Energy’s revenues in 2004 came from the default rate, although it was not a rate approved by the regulator. [ 151 ] Mr.

Weiss also believed the likelihood of margin erosion, an outgrowth of deregulation, presented significant risks for ENMAX Energy. The erosion would occur as existing contracts came up for renewal in an increasingly competitive market. [ 152 ] Mr. Weiss also considered senior management turnover, lack of geographic diversification and the heavy concentration of ENMAX’s market in the Calgary area, which itself is exposed to significant economic disruption because of the dominance of the oil and gas sector. [ 153 ] Mr.

Weiss rated ENMAX Energy’s business risk as “weak” on a numeric scale, or mid-to-low in the BB category. This compared to Standard & Poor’s rating of ENMAX Corp.’s business risk as average, and the fact that some of Moody’s risk factors might tend to indicate a medium risk for ENMAX Energy. [ 154 ] For ENMAX PSA, he emphasized the single asset nature of its business and its exposure to market risk by selling into a spot market. [ 155 ] By contrast, Mr. Levey found both entities to be a medium business risk (ENMAX Energy being in the lower-risk part of the range).

He viewed ENMAX Energy as having a mix of regulated and unregulated business, holding the view that roughly 60% of its sales were covered by some form of regulation, which tends to moderate risk. ENMAX Energy had a very strong position in the Calgary area and its own forecast was that it would grow along with the market. He recognized the ENMAX experts’ reference to the likelihood of some margin erosion, but he did not see that as a big concern. The goal of an industrial company, he said, is to maximize profits, not profit margins.

He noted references to some management changes, but did not see them as being an unusual or significant factor. [ 156 ] The main difference between the experts in assessing financial risk was the interest rate they used to drive the financial analysis. In analyzing ENMAX Energy’s financial prospects, Mr. Weiss used 11.5% as the interest rate for payments on the $497 million debt. He considered this acceptable practice: when a company comes in with a financial position, the rating agency should use the company’s suggested rate.

He acknowledged an element of circularity in the analysis: using an 11.5% interest rate to calculate key financial metrics, which played a role in determining the credit rating, which played a large role in determining an interest rate the markets would have determined for a debt issuance. [ 157 ] In his analysis, Mr. Weiss did not review ENMAX Corp.’s 2004-2008 Base Strategic Plan, in which projections assumed an unregulated interest rate for ENMAX Energy of 6.8%.

Likewise, he was not aware that in its application to the AEUB, ENMAX Energy requested carrying costs for 2005 based on an assumed interest rate of 5.777%. [ 158 ] Further, Mr. Weiss confirmed that he used interest charges for all of 2004 in his financial analysis, even though the debt was not incurred until December 2004. By using the rates set in the intercompany notes for his financial projections, Mr. Weiss obtained worse results than Mr. Levey, who used a much lower rate derived from data based on the type of business risk he assumed. [ 159 ] In assessing ENMAX Energy’s financial risk, Mr.

Weiss noted its projected profitability was weakening by margins falling off over time. The company was very highly leveraged; because of the $497 million in debt the cash flow position would be tight, in large part because of the required interest payments on the intercompany note.

[ 160 ] Mr. Levey prepared a set of pro forma financial projections representing the anticipated effects of the debt transaction. He used ENMAX’s financial projections, but considered it necessary to arrive at his own assumption of an interest rate. He assumed a 5.8% interest rate, finding this to be a typical rate for a utility company with a medium business risk. [ 161 ] He strongly disagreed with Mr. Weiss’s use of the intercompany note interest rate of 11.5% when analyzing financial risk. This approach, he said, was arbitrary and circular.

Putting a very high interest rate into the financial projections would lead to a very poor financial risk, notwithstanding a better business risk, and generate a poor credit rating, and thus a high interest rate. Mr. Levey stated that it is standard rating agency practice to begin the quantitative portion of a rating analysis by utilizing an interest rate consistent with the company’s business risk. [ 162 ] To test his analysis, he also did projections using Mr. Weiss’s BB business risk rating, which lead to an assumed interest rate of 6.25%, using the same data that generated his 5.8%.

He also did projections based upon interest rates of 6.8% and 7.8%. None of these calculations affected his ultimate credit rating. [ 163 ] Mr. Levey acknowledged that in Standard & Poor’s analysis of ENMAX on a consolidated basis, it added a $240 million capital adequacy charge (“CAC”) to total debt, which represents a debt-like obligation to account for swings in capital requirements associated with trading operations. Mr. Weiss used the same approach. Mr. Levey argued the practice was not established and he declined to add the CAC. Rather, he treated it as an operating cost.

His approach reduced the company’s profit margin and had the effect of reducing total debt load, as compared to Mr. Weiss’s approach. b. Implied credit profile and parental support [ 164 ] After completing the business risk and financial risk analyses, Mr. Weiss assigned an implied credit profile of B to ENMAX Energy. This was his credit rating for ENMAX Energy as the issuer, on a stand-alone basis.

The rating put ENMAX Energy well below the line commonly used by investors (although not formally by credit rating agencies) dividing investment grade credit ratings and non- investment, high yield or speculative grades. By contrast, Mr. Levey concluded that the stand-alone credit profile for ENMAX Energy was in the BB rating category. [ 165 ] As part of his credit ratings for ENMAX Energy and ENMAX PSA as issuers, Mr. Weiss addressed whether their ratings might be improved by implicit support from their parent, ENMAX Corp.

His opinion was that there must be a compelling reason to expect a parent to provide support to a subsidiary in order for the credit rating to be boosted. He found no compelling reason (even for support for one missed payment). Further, because ENMAX Corp. was 8 and 9 notches, respectively, above ENMAX Energy and PSA, the gap was too great for any form of “credit lift.” In his view, the greater the gap, the more need for evidence of likely parental support. [ 166 ] He acknowledged that ENMAX Corp. provided guarantees to both subsidiaries as required for their participation in various aspects of their markets.

There were potential economic incentives for ENMAX Corp. to support the subsidiaries in the event of difficulty, but it did not persuade him to improve their ratings. [ 167 ] He was presented with examples of ratings in which he had been involved at Standard & Poor’s, where subsidiaries of Amoco were given credit ratings better than their stand-alone profiles would justify, because of implicit parental support. He did not view these as comparable.

Further, he was not persuaded by the fact that ENMAX Corp. waived covenants and accelerated the date of its second loan to ENMAX PSA as indications that parental support would be given in financial difficulty. [ 168 ] Central to his considerations was that ENMAX Corp. could not use regulated assets to support its subsidiaries and that the regulated business (transmission and distribution) could survive even if the unregulated activities of ENMAX PSA and ENMAX Energy did not.

Simply put, he believed that if the subsidiaries encountered financial difficulties, there was no compelling reason to believe that their parent would come to their aid. [ 169 ] Mr. Levey, on the other hand, considered the willingness and ability of ENMAX Corp. to support ENMAX Energy during times of financial stress. He concluded that many of the stand-alone risks associated with ENMAX Energy would have been mitigated by a strong likelihood of parental support. [ 170 ] Willingness would be motivated by business considerations, mainly the strong integration within the ENMAX group.

There would be a financial impact on ENMAX Corp. if support was not forthcoming, because of guarantees it had given and the significant portion of its revenues being generated by ENMAX Energy. Finally, ENMAX Corp.’s reputation would be damaged if it did not support ENMAX Energy, likely leading to a down grade of its own credit rating, and a damaged reputation with suppliers and creditors, staff, regulators and the credit standing of the City of Calgary as

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