FINAL REPORT OF THE PANEL UNDER CHAPTER 18 OF THE CANADA-UNITED STATES FREE TRADE AGREEMENT

52. The task of the Panel is to apply the general words of definition in Article 304 (the two-pronged test) to the balance of our terms of reference by the simple process of reasoning from what the Parties have said is "reasonable" to the other matters on which the Parties have sought our determination, but which are not referred to expressly in any of the illustrations. In particular,

53. The first question is whether interest should be "included" in respect of a loan to acquire real property in circumstances identical to subparagraph (e) except that the loan is not secured by a mortgage on the real property so acquired. The basis for inclusion, if any, must be found in the two-pronged definition in the opening words of Article 304. It does not emerge, at least explicitly, from any of the other illustrative subparagraphs.

54. Both Parties submitted references to statements by the United States Financial Accounting Standards Board (FASB). Canada relied on the FASB Statement of Financial Accounting Standards No. 34, paragraph 48 (October 1979) which reads in part:

In the Panel's view, a cost that is "analogous to a direct cost", and is "readily and objectively assignable to the acquired asset", exhibits the necessary relationship to the means of production required by Article 304 for inclusion in the value content calculation. The point is that interest must be "readily and objectively" assigned to acquisition of a production asset. This will give rise to questions of proof. In its first submission, Canada gave as an example the possibility that a loan agreement may require dedication of proceeds to production assets. ²² The Panel has not heard argument on what, if any, other factors or procedures may amount to a sufficient objectively established connection with production assets for an allocation of interest costs to be "reasonable."

55. The requirement to establish a relationship between use of loan proceeds and the production of goods is the same whether or not payment of the purchase price is secured by a mortgage on the acquired asset. The significance of the mortgage, after all, lies in the remedies it offers to the mortgagee in the event of a default on payment. The mortgage is an invisible web of rights and obligations that neither enhances nor impedes the work of the capital asset secured by it in the production of goods. Article 304 is concerned with the production of goods, not with the remedies of unpaid creditors. Nevertheless, it is the view of the United States that even if non-mortgage interest costs incurred in the acquisition of land, plant and equipment used in the production of goods could reasonably be allocated to the production of goods, the Parties have nevertheless agreed that such non-mortgage interest should be excluded from the value content calculation.

56. The United States submitted that subparagraph (g) is a complete answer to the Canadian position. For ease of reference we repeat the wording of (g) here:

57. In the United States view, the provision of credit is a "financial service" and the cost of credit is therefore a cost relating to the provision of a financial service. Accordingly, it is argued, interest costs have been characterised by the Parties themselves in (g) as a "general expense of doing business", and interest therefore must be excluded from the "direct cost of processing or direct cost of assembling" unless it can be brought within the "narrow exception" of mortgage interest in subparagraph (e). This exclusion, the United States says, must be given effect even if such costs are "reasonably allocable" to the production of particular goods because they are "explicitly disallowed" by Article 304.

58. The Panel cannot accept that subparagraph (g) has either the meaning or the paramountcy which the United States Submission attributes to it.

59. Firstly, for the reasons already given, the Panel has concluded that the enumerated lists are merely illustrative, and do not establish amongst themselves any hierarchy of importance or paramountcy. Even if the expression "financial services" were intended to cover interest cost, it would not by the fact achieve the superior status of "a general rule" within the overall framework of Article 304, to which other subparagraphs would operate only as narrow exceptions. The United States in its Second Submission ²³ states that its overall analysis of Article 304

If subparagraph (g) were expressed in these words, of course, the United States' argument would stand on somewhat stronger footing, but that is not the language chosen by the Parties in the Free Trade Agreement. The Panel is bound to respect the language that the Parties have in fact employed.

60. Secondly, the financial services referred to in (g) are grouped with other types of services including advertising, accounting and legal services. Interest represents the cost of money, not the cost of service. The United States itself defined interest as "the cost of money borrowed" and "the value, or cost of money over time." ²⁴ In the Panel's view, it would distort the "ordinary meaning" of words to characterize the cost of money as the cost of a service. The principle of treaty interpretation set out in Article 31 of the Vienna Convention on the Law of Treaties and accepted by the Parties as appropriate requires us to interpret Article 304 in accordance with the "ordinary meaning to be given to [its] terms." A financial institution may offer a wide variety of financial services for which fees are paid that may have nothing to do with interest charged on the balance of outstanding loans. The chief financial officer of a manufacturing company and his/her staff also provide a variety of financial services. In this regard the Panel agrees with the arguments made by Canada. ²⁵ The Panel also regards the definition and use of the term "financial services" in the Draft Final Act of the Uruguay Round as not being relevant to the issue before the Panel, in light of the dissimilar contexts in which the terms appear.

61. Thirdly, if the submission advanced by the United States were correct, all interest would be excluded under the "general rule" established by subparagraph (g) except such mortgage interest as is specifically permitted under subparagraph (e). The Parties apparently did not share this view, because they did not treat subparagraph (g) as a general exclusion but went on to provide specifically for a type of "excluded" mortgage interest in subparagraph (l) in respect of real property used for administrative purposes.

62. The United States chief negotiator for Article 304 told the Panel that a mutual objective of the Parties in the FTA was to tighten up the value content calculations permitted under the Autopact. However he could recall no discussion with Canadian negotiators to the effect that subparagraph (g) was to be regarded as a general prohibition against allowance of interest. ²⁶ Moreover, he could not recall any discussion about the meaning to be attributed to the expression "financial services" in subparagraph (g). The FTA on its face does not disclose any mutually agreed upon hierarchy of "illustrations", or any mutually agreed upon expanded meaning of the term "financial services". It is true, as the United States points out, that if real property mortgage interest was already included in Article 304 prior to Canada's request to mention it expressly in October 1987, Canada's request was superfluous. It is also true, as Canada points out, that while efforts to "tighten up" the value content rules in the Autopact resulted in the FTA's express disallowance of such items as profit and advertising expense, there was no such express disallowance in the case of interest. The "negotiating history", such as it is, does not offer a solution to the impasse.

63. In summary, the Panel does not accept the reference to "financial services" in subparagraph (g) as a proxy for an express disallowance of interest. In the Panel's view subparagraph (g) does not provide any significant assistance in the resolution of the questions submitted. We believe the test of "reasonableness" in connection with interest should focus on the juxtaposition of subparagraphs (e) and (l), not (e) and (g). The subject matter of subparagraphs (e) and (l) is identical whereas the subject matter of subparagraphs (e) and (g) is quite different.

64. The terms of reference require the Panel to evaluate the importance of the legal form of the transaction giving rise to the interest obligation. The Panel was asked to determine whether

65. The Panel fully recognizes that mortgage interest is paid pursuant to a formal document whose terms can be easily ascertained. Although the mortgage document will not ordinarily explain the use to which the proceeds of the mortgage were put, the accompanying loan documentation may well do so. Such documentation would help establish an objective basis on which "reasonably" to allocate that interest to production. The negotiators of Article 304 may have considered that an independent bank or other financial institution, as opposed to a related corporation would be more likely to take mortgage security. Loan transactions with independent banks and other financial institutions would normally be concluded on arms-length terms. Government authorities could readily verify the interest cost, identify the real property included as security, and verify whether in fact the proceeds of the loan secured by the mortgage are used for the production of goods.

66. There are thus a number of features of a mortgage which may have led the negotiators to single out mortgage financing for special mention. It does not follow, however, that these features should determine what is "reasonable" for the purpose of an Article 304 allocation.

67. Firstly, the same features apply equally to a chattel mortgage of personal property, yet the list of illustrations refers only to mortgages of real property.

68. Secondly, and more generally, difficulties of proof in particular cases should not artificially restrict the meaning to be applied to the general words of Article 304. The words of the two-pronged test must, according to the Vienna Convention on the Law of Treaties, be given their "ordinary meaning".

69. If mortgage interest on all of the fixed means of production is considered by the Parties to be a "reasonable" allocation to the "direct cost of processing or the direct cost of assembling", the Panel cannot find anything in the text or context of Article 304 to suggest that the Parties considered the form of the security (if any) or other aspect of the form of the financing, whether by mortgage or otherwise, to be of controlling importance. While mortgage financing may present advantages in terms of verification, it cannot be contended that mortgage financing is the only method of financing for which such verification is possible. The Free Trade Agreement, taken as a whole, suggests no compelling reason to require producers to finance the acquisition of the means of production by mortgages rather than other methods of financing which may, in particular circumstances, be more commercially appropriate. The Parties to the Free Trade Agreement have no particular vested interest in mortgage financing, and producers should not be required to make financing decisions based on governmental convenience in the verification or audit in the absence of some express agreement to that effect in the FTA itself.

70. In its submissions, the United States drew attention to the potential for abuse if non-mortgage interest were to be included:

This, the United States implied, does not involve interest at all. Rather it involves a transfer of profit from a parent corporation to a subsidiary. Article 304(m) makes it clear that a transfer of profit may not "reasonably" be allocated to the production of goods. While some producers may seek to accomplish this indirectly (e.g. by dressing up profit as interest to try to qualify it as an included cost), the potential for such an abuse exists whether or not the abusive "loan" is secured by a mortgage on real property. The problem arises generally from the fungible nature of money and the difficulty of unequivocally associating the proceeds of a loan with the acquisition of specific property. But this problem applies even when the loan is secured by a mortgage on real property. The proceeds of a mortgage on real estate may be diverted to an ineligible purpose. The interest rate on a mortgage on real property may be inflated in a non-arms length transaction to strip profit out of a subsidiary.

71. In the Panel's view, this potential for abuse should be dealt with in the same way whether a loan is secured or unsecured, whether for the purchase of real property or for the purchase of other production assets. The interest must be bona fide, the transaction must be on terms that are at arms length and the borrowing must be in the ordinary course of business to finance the production of goods. These requirements are implicit in Article 304 itself, for if they are not met then it could not be said that the interest cost, "can reasonably be allocated" to the production of those goods. ²⁸

72. It follows that in the opinion of the Panel, in light of the fact that the Parties considered inclusion of mortgage interest in respect of the acquisition cost of production-related real property to be reasonable, inclusion of non-mortgage interest in respect of the acquisition cost of such real property is also reasonable.

73. The United States submits that interest should not be permitted on any machinery and equipment used in the production of the goods because of a negative inference that the United States believes should be drawn from subparagraph (c) of Article 304, which reads as follows:

74. The United States points out that the Parties saw fit specifically to mention depreciation and maintenance of machinery and equipment, and suggests that had it been the intention of the Parties to permit the deduction of interest in respect of machinery and equipment the Parties would have said so in clear language.

75. There is some appeal in this argument. Clearly the Parties went to some trouble to make some of the illustrations quite comprehensive. Interest is mentioned in combination with maintenance and depreciation in subparagraphs (e) and (l), and its absence from subparagraph (c) is notable. The question, however, is whether this fact justifies drawing a negative inference that interest on machinery and equipment should be excluded despite the existence of circumstances that would call for their inclusion under the two-pronged definition in the opening words of Article 304.

76. In the case of machinery and equipment fixed to the soil or to a plant, of course, any negative inference would be refuted by the inclusion of fixtures as "real property" under subparagraph (e). If interest may be included in respect of "fixed" machinery and equipment, there seems no basis on which to draw a selective negative inference from subparagraph (c) in respect of unfixed machinery and equipment, because subparagraph (c) makes no distinction as to whether the machinery and equipment is fixed or unfixed.

77. Adoption of the "negative inference" approach would produce some clearly undesirable effects elsewhere in Article 304. Some of these have already been noted. For example, subparagraph (l) excludes mortgage interest on real property used by personnel charged with "administrative functions", but does not explicitly exclude mortgage interest on real property used by personnel charged with sales, advertising or marketing functions (or, for that matter, non-mortgage loans whose proceeds are used for administrative purposes). Subparagraph (k) excludes royalties related to "a licensing agreement to distribute or sell the goods" but does not expressly exclude such royalties payable otherwise than by a licensing agreement. Neither of the Parties have suggested, or would be likely to accept, an application of the "negative inference" approach in such cases.

78. In subparagraph (a) mention is made of the inclusion of various labor costs "whether provided by employees or independent contractors". A "negative inference" approach would suggest that where this qualification is not specifically mentioned only the cost of services provided by employees of the producer are to be taken into consideration. Such a "negative inference", however, would drastically truncate the obviously intended scope of subparagraph (g) so that for example only advertising, marketing, accounting, legal and financial services rendered by the producer's employees would be addressed. The United States points out that such an interpretation:

In short, the Panel does not accept the "negative inference" approach to Article 304, and concludes that the absence of any reference to "interest" in subparagraph (c), while curious, does not exclude interest that would otherwise be included on the basis of the general division between "production" uses and non-production uses evident from a reading of Article 304 as a whole.

79. It follows that the issue of interest on the acquisition cost of machinery and equipment must be addressed on a broader basis of principle. In the Panel's view, this broader basis is to be found in the general demarcation between production uses and non-production uses. In our view subparagraph (e) contemplates as reasonable the inclusion of interest on the cost of acquisition of real property used in the production of goods not because it is real property but because the acquired asset is used in the production of goods. On that basis there seems no reason to differentiate between real property means of production and other means of production.

80. As stated earlier, while the text and context of Article 304 call for detailed examination in the process of interpretation, other compelling sources of interpretive assistance are to be found in the object and purpose of the FTA and its rules of origin, of which Article 304 forms an important part.

81. It is clear from the Preamble of the FTA, and from the Objectives and Scope of the FTA set out in Chapter 1, that the Parties sought to create a trading arrangement whose benefits would accrue primarily but not exclusively to the goods and producers of the Parties, and to enhance employment and income opportunities primarily but not exclusively for persons living within the territories of Canada and the United States.

82. The question put to the Panel deals specifically with interest on debt incurred for the acquisition of fixed assets. As already stated, we recognize that money is fungible, and it is therefore especially difficult to connect the proceeds of debt unequivocally with any particular good or function. Nevertheless, Article 304 expressly allows mortgage interest on real property, notwithstanding the fact that the funds raised by a mortgage are fungible and may be traceable to the production process only in a formal sense. It must therefore have been the view of the Parties that the inclusion of interest, as such, is not inconsistent with the larger objects and purposes of the FTA. Once this basic policy is established, the Panel does not believe that the form of security (if any) securing the debt in respect of which interest is payable is determinative, and accordingly we conclude that unsecured debt to acquire fixed production assets should also be counted. However, as we have emphasized, our determination that in a given case interest can "reasonably" be allocated to production presupposes that a producer can demonstrate to the relevant government authorities, if required to do so, that the interest is bona fide (for example that it is not incurred as part of a sham intracorporate loan transaction); that the interest is payable on arm's length terms (for example the interest rate has not been inflated artificially to increase the costs of production); that the loan has been undertaken in the ordinary course of business; and that the proceeds of the loan are objectively assignable to the production of goods.

83. The question submitted to the Panel focuses on the legal form of the transaction giving rise to the interest obligation. It follows from our analysis that the form of the debt is not a controlling circumstance. The relationship of the debt in respect of which interest is claimed to the production of goods is the key to the interpretation of Article 304.

84. Accordingly, the Panel DETERMINES that:

85. The Panel RECOMMENDS that the Parties resolve the dispute by the adoption of such regulations and internal administrative procedures as may be necessary to implement the Panel's determination. The Parties may wish to consider the adoption of regulations and procedures that would address the particular problems of establishing an objective, traceable connection between a loan and production assets, the scrutiny of intracorporate loans, and the ascertainment of ordinary business practice.

SIGNED IN THE ORGINIAL BY:

²² Canada First Submission, p. 19, para. 51.

²³ U.S. Second Submission, p. 14.

²⁴ U.S. First Submission, p. 25.

²⁵ Transcript of Oral Hearing, pp. 26-27.

²⁶ Transcript of Oral Hearing, p. 96.

²⁷ U.S. Second Submission, p. 7.

²⁸ Although the question relating to the situs of the lending institution has been excluded from consideration by the Panel, one member felt that the situs of the lender could form an additional requirement for the inclusion of non-mortgage interest for purposes of Article 304.

²⁹ U.S. Second Submission, p. 14, footnote 6.