Friday, 7 August 2015

A footnote from the federal Tax Court

The no-longer-confidential 2014 financial statement of Imperial Tobacco Canada Ltd  (ITL) that was made public late last month contained an intriguing "note 6" regarding a dispute over a tax bill with the federal and provincial governments that was abandoned by governments last fall.

It involved the treatment of moneys received by ITL from their sister companies, British American Tobacco Australia and British American Tobacco Italy Investments. ITL had been served with an assessment for more taxes in 2010, and its appeal against that demand opened a file with the federal Tax Court.

The registry for the Tax Court is a pleasant walking distance from my home, and I dropped by yesterday afternoon hoping to learn more about this case and why the governments would have dropped their demand for more than $100 million.

It would appear that I am not the only one to have found this an interesting case -- the 6-inch file is peppered with receipts for copies sent to tax law firms across Canada over the past few years.

Spaghetti ownership and tax deductions

Corporate tax is dizzying enough without ascending to the thin atmosphere of intercorporate transactions, so my grasp of the situation is far from confident. Fortunately, the Revenue department offered a readable summary of events:

  • In late 2001 (shortly after BAT assumed control of ITL), the company purchased almost $500 million in preferred shares of BAT Australia (BATA), for which it received annual payments of 7.6%. This allowed BAT Australia to reduce its taxes in its home country, as the payments to Canada were recognized as a debt under their tax law.
  • ITL in turn borrowed money to pay for these shares, paying almost as much money in interest for the loan and insurance from BAT as it received from BATA. Its net return on the investment was slightly over one tenth of one percent (0.1203%) - representing only $582,144 in additional income.
  • But just as the agreement reduced taxes payable to the Australian government, it also was used to reduce the tax-bill in Canada by about $12 million per year.

  • Canada Revenue smelled a rat and challenged the deduction. "It can reasonably be considered that the principal purpose for the acquisition of the BATA Preferred Shares by ITCAN was to avoid, reduce or defer the payment of tax otherwise payable by ITCAN", it told the court.
  • A similar arrangement was negotiated a couple of years later, after BAT acquired the Italian state-owned tobacco company ETI. This time $880 million was invested with a loan from a BAT company (BATIF), and the return on investment was almost one percent (072%). The tax benefit was three times as large.

The Federal Court of Appeal cements this right to avoid taxes

Most of the documents related to disputes about claims of privilege that ITL wanted to make on documentary evidence behind these transactions.

The only hint about why the case was dropped last winter was reference to a decision of the Federal Court of Appeal regarding a similar dispute with Lehigh Cement which restricted how the government could apply the general-anti-avoidance rules on such investments.

And so BAT is able to reduce its taxes in Canada and Australia by generating a little cross ownerhip amongst its subsidiaries. Will the tax act be amended to remove their right to do so? And when?

Saturday, 1 August 2015

The no-longer confidential financial statements

Although the tobacco companies convinced the Quebec Court of Appeal to relieve them of the obligation to make an advance payment on the money they owe some Quebec smokers, they did not convince the three judges that the financial statements they used when making their arguments should remain a secret.

To be more exact, the two companies that had requested confidentiality (Imperial Tobacco and Rothmans, Benson and Hedges) have now had their current financial statements made available to the public. Earlier this week I made a pleasant day-trip to Montreal and came back with some of these no-longer confidential records, including:

These documents deserve review by someone versed in accounting. Certainly there are a few surprises.

For one, it would appear that last year ITL joined JTI-Macdonald as a money-losing operation. In 2014 it posted a loss of $351 million dollars - JTI's ongoing annual loss of about $7 million is on record as a result of Justice Riordan's ruling.

Further up the balance sheet, both companies have positive and substantial profits on operations, as shown below. But a second surprise in is how much less profitable Imperial Tobacco is than it was historically.

Until about 2004, ITL was required to submit an annual report to the Toronto Security Exchange. At that time, its earnings per cigarette exceeded a dollar per package of 25 cigarettes

Today, their earnings per package, once inflation is taken into consideration, are about half as much. (Sales data below is taken from Euromonitor estimates of manufactured cigarette sales in Canada in 2013, which they say represent over 92% of all tobacco profits)

Profit from operations
Millions of packages of 25 cigarettes sold
Operating profit per package

Why is PMI/RBH so much more profitable than BAT/ITL?  If there has been such a dramatic fall in ITL profits, why has this not been identified in presentations made by BAT to investors? Your guess is as good as mine.* 

Those interested in other strategies used by ITL to reduce taxes will enjoy reading Note 6 on its Financial statement in which it reports on its victory against revenue departments after a prolonged dispute about "controlled foreign affiliate dividend deductions." 

* (My bet is that following the shift in production to Mexico, ITL adopted a transfer pricing strategy to split its profits on Canadian sales between two separate BAT subsidiaries.)