Accounting scandal at BC Rail?

The documents police seized at the BC legislature in December may be tied to the vastly under-priced hidden accounting assets CN acquired when it purchased BC Rail

by Kevin Potvin <kpotvin@republic-news.org>

It's too early to tell what lies behind the December 30 seizure by police of 30-some boxes of documents from the provincial ministry of transportation and finance offices. Most speculation, and there is lots of it, has focused on loose comments made by police spokespeople about organized crime and illicit drugs possibly being involved.

Overlooked is the intimate connection between the seized files, the offices they were seized from, and the people known to have been asked by police for further documents, and the tentative November sale of state-owned BC Rail to private multinational rail operator CN.

Following the controversial sale and the rise of public outcry over it, the Liberal regime contracted outside consulting firm Charles River Associates to examine whether the Province received fair value in its sale of BC Rail operating concessions to CN.

The total value of the sale was $1 billion. The package was comprised of two components. $750 million was paid by CN to the Province in exchange for the right to operate rail operations for 60 years on the rail beds that will remain state-owned. Charles River Associates calculated that CN can anticipate about $6.7 billion in income over the 60-year life of the deal. That averages out to about $111 million a year on the $750 million investment, or about a 15% annual return. This, according to Charles River Associates, is about right when the deal is compared to similar deals elsewhere in the world.

It is in the second component of the deal where mystery arises. CN paid a further $250 million to the Province in order to acquire interesting tax shelters on the books of BC Rail worth an estimated $2 billion and possibly considerably more.

When a company purchases equipment, it does not need to declare the total value of the purchase on its tax return for that year. Instead, the company can apportion parts of the purchase price of the equipment over several years of tax returns. Companies like to do this so that they can reduce the profits they need to declare on their future tax returns, and for which they are liable to pay tax on.

Equipment purchases that still have remaining unused value that can be declared on future tax returns are an asset for a profit-making company. Another company that wishes to reduce its taxes by reducing the profit it needs to declare may wish to purchase the first company solely in order to acquire these un-depreciated purchases from the other's past for its own future tax returns. BC Rail, at the time of its sale to CN, had $1.2 billion in un-depreciated capital purchases on its tax books, a rather attractive asset for profitable CN.

Furthermore, BC Rail also had on its books operating losses that can be carried forward to future profitable years. When a company loses money over the course of a year's operations, it can carry forward those losses to a future year when it experiences profit, and reduce the taxes it needs to pay. It can simply deduct from profit enough of its past losses to reduce its profit, as far as tax returns are concerned, to zero, ending up liable for no taxes in that profitable year.

Other companies can purchase a company with carried-forward operating losses in order to apply those losses to its own profits and thus reduce the taxes it needs to pay. At the time of the sale of BC Rail to CN, BC Rail had about $800 million of carried-forward losses on its books.

Combined with the $1.2 billion in un-depreciated capital purchases, CN acquired in total $2 billion worth of tax shelter instruments for the princely sum of $250 million. Tax shelter instruments are extremely important to profitable companies because provincial and national corporate income taxes in British Columbia grab 38% of a company's reported profits in its tax returns. Reducing the profits a company must report reduces the taxes it must pay to governments. Companies with large carried-forward losses and large un-depreciated purchases have become increasingly attractive targets for take-over by larger, profit-making companies. It is often the case that the interest one company has in taking over another company is almost solely in the hidden value contained in its tax books, and can have little or nothing to do with its real assets or operations. BC Rail's $2 billion worth of tax shelter instruments may have been the real prize CN was after, while the actual assets and operations of BC Rail, worth just a potential $111 million annually, was simply a throw-in to legitimate the deal.

The firm hired to assess whether the Province received fair value in its sale of BC Rail explicitly disavowed any capacity to assess the value of the tax shelter instruments comprising the second half of the deal. The report generated by Charles River Associates states that, "historically, BC Rail has paid no income tax because of its relatively large backlog of" of tax shelter instruments. "We did not attempt to model the prospective tax strategies of an acquiring company," the report states.

The report further states that "We cannot offer much insight on the sale price" of the tax shelters "because we are not privy to the detailed data that would be required to assess a particular company's situation." The firm hired to assess the government's handling of the sale of BC Rail ended up simply trusting what the government said about its own transaction: "It is our understanding," Charles River Associates concluded, "the Province did compare the sale price of the [tax shelter instruments] to the potential future tax revenue that would be generated for the Province if the acquiring company did not have access to BC Rail's" tax shelter instruments. There is no documentation offered in the report to justify the authors' "understanding."

The report goes on to conclude, "It is safe to assume that there is sufficient inventory of [tax shelter instruments] to offset CN's income tax obligations to the Province of British Columbia for at least 25 years," and further, that "any future income tax revenue after 25 years is negligible."

This is an astonishing statement. If it's true that CN can expect to earn $6.7 billion in the next 60 years with BC Rail, and if the tax shelter instruments allow CN to avoid federal taxes as well, the $250 million portion of the sale is potentially worth more than $2.5 billion to CN, just on its operations of BC Rail alone. As the report explicitly states, "We can assume that in the future, CN will use the [tax shelter instruments] acquired as part of the BC Rail transaction to avert paying taxes." But the report further states that CN's entire operations in British Columbia, after acquiring BC Rail, will not be liable for any taxes because of its acquisition of BC Rail's tax books.

We don't know the size of CN's prior operations in British Columbia, but it is a substantial operator in this province. If its operations were roughly equal to BC Rail's operations prior to the purchase, then the benefits to CN in its purchase of BC Rail's tax books would exceed $5 billion. Had Charles River Associates evaluated the total value of the sale of BC Rail to CN, they would have concluded the package was worth close to $12 billion in anticipated profits to CN. If it's true that $750 million was a fair price to pay for the $6.7 billion in anticipated income from BC Rail operations, then it stands to reason that $12 billion in effective income should have been sold for no less than $1.75 billion. CN paid in total only $1 billion.

That $750 million gain is no chump change. The firm hired to assess the fairness of the deal admitted in its own report that it was not privy to the information necessary to do its job. It states that it relied on a vague understanding that someone in the finance or transportation ministries assessed the value of the hidden tax shelter assets on BC Rail's books at $250 million, instead of the $1 billion they may be worth.

Whoever within these ministries provided this understanding to the government and to the firm that assessed the fairness of the deal would have been in a key position to personally profit by arranging a $750 million gift to the executives of the private company, CN. Given recent scandals to do with accounting irregularities at large private companies like Enron and WorldCom, it is by no means a stretch to imagine police here have uncovered our own accounting irregularity scandal involving dodgy tax shelters in a hushed-up deal between multinational CN and officials of a government friendly to big business and a political party heavily supported by campaign contributions from them.

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