The Vanishing Income Tax Trick

Previously, we learned about the incredible cash machine that is Sirius XM Canada.

We saw how its operating activities between 2011 and 2016 generated so much cash that its shareholders have received far more in dividends than they ever invested in the company – all without the company paying any income tax.

The engine of this cash machine is the company’s monopoly. In the six years it was a public company, it took in $1.66 billion in revenue. Without competition, Sirius XM Canada can charge far more for its services than it costs to provide them.

But why didn’t it get taxed on all the money it earned? Let me explain Sirius XM Canada’s tax avoidance strategy during the period in question.

Step 1: Related-party transactions

The first step was to reduce its taxable income through related-party transactions. As we saw in an earlier article, a substantial portion (21%) of its operating expenditures were actually paid to two of its shareholders, CBC and Sirius XM US. These expenditures were mainly for intangible things like radio content. There was no incremental cost to the two shareholders to provide this content, as it was already being produced for broadcast on CBC Radio in Canada and on Sirius XM in the US.

The $17 million that went to CBC was not taxed because CBC, as a public cultural institution, operates at a loss. It is not tax exempt, but it doesn’t have any taxable income. The $260 million that went to Sirius XM US was never taxed in Canada. These expenses, along with its other operating expenses which were at arm’s length, left Sirius XM Canada with $195 million in operating income.

Step 2: Financing expenses

The second step was to further reduce its taxable income through financing. By leveraging with debt and by refinancing its debt twice during the same period, the company effectively replaced the shareholder’s investment with borrowed money, at the cost of $91 million in financing expenses. These took the company’s operating income of $195 million down to a taxable income of $104 million, or about 6% of revenues.

Step 3: Non-cash tax expenses

On its income statements, the company said it had a total tax expense of about $28 million on the $104 million in taxable income. This is pretty much exactly what the tax would have been using the statutory tax rate of 26.5%.

There’s one problem. This was just a tax expense, not a tax payment.

What’s the difference? Well, it has to do with how corporate income tax works.

When a company has taxable income (its taxable revenue is greater than its tax-deductible expenses), it owes income tax. But unlike you and me, if the company has a taxable loss (its tax-deductible expenses are greater than its taxable revenue), it can claim a refund of tax paid in previous years.

Of course, if the company hasn’t ever earned a profit, there will be no taxes from previous years to get back. In that case, the company just hangs on to its taxable loss to reduce its taxable income in subsequent years. This is called a tax loss carry-forward, because the company is carrying the tax loss forward into the future.

If the company ends up with more tax losses than it has taxable income, it is able to reduce its taxable income to zero. It will show a tax expense in that year, but it won’t have to remit any cash to the government. This is what Sirius XM Canada did for six straight years.

How do we know this? From the cash flow statement. As we learned in a previous article, the “operating activities” section of the cash flow statement typically starts with the company’s net income and then adds back any expenses that didn’t actually involve a cash expense. These include, for instance, the expenses for amortization and depreciation. They have nothing to do with cash whatsoever. They simply represent this year’s portion of cash expenditures made in previous years, when the company purchased its assets. I’ve highlighted this on Sirius XM Canada’s cash flow statement for 2016:

All the other expenses that didn’t involve cash are also added back. On next line of the cash flow statement, you see this:

The highlighted line exactly matches the amounts shown for income tax expense on the income statement:

This is how we know that the income tax expense didn’t involve any payments to the government. For six straight years, the income tax expense for Sirius XM Canada was merely a representation of what the company would have paid in tax that year if it hadn’t carried forward its tax losses from previous years.

Six years, $104 million in taxable income, $28 million in tax expenses, zero tax paid.

So what gives? Was the company cheating?

No, it simply used its merger to exploit our tax code. We’ll look at that next, when we wrap up this series on Sirius XM Canada.

Photo of blue jeans by the side of the road taken in Crescent Beach, BC in 2012. And no, I don't know how the person wearing them vanished.