How Tax Drives Mergers

And so we reach the end of this series on Sirius XM Canada.

We have seen how the company has avoided paying any income tax on the $1.66 billion in revenue it took in from 2011 to 2016, while nonetheless paying $286 million in dividends to its shareholders and another $277 million in revenue to two of these shareholders, Sirius XM US and the CBC. And it has done all this using other people’s money, after effectively replacing its shareholder capital with long term debt.

The trick to the vanishing income tax, we found out, was to use accumulated tax losses to cancel out its taxable income during this period. Our question today is, where did those losses come from? Once we have answered this, I want to consider what this series of articles says about the corporation as a taxable entity.

Deferred Tax Assets: the Magician’s Rabbit

As I have been careful to point out, Sirius Canada XM’s scheme was entirely legal. The company merely exploited Canadian tax regulations. But it did so with a magician’s virtuosity.

The sleight-of-hand in this case was accomplished using deferred tax assets, which are accumulated tax benefits that the company can use to reduce its future tax payments. How does a company get these assets?

Tax assets can arise due to timing differences between the company’s taxable income and its accounting income. A company issues its income statement to tell external audiences about it financial performance over the year. On the income statement, it recognizes revenue and expenses based on financial accounting regulations.

But accounting regulations are not quite the same as tax regulations. The tax expense shown on the income statement is therefore never going to match the actual amount of tax paid. So, for most companies, you will see both deferred tax assets and deferred tax liabilities reflecting these differences, which will resolve over time.

Tax Losses

But there is another way that tax assets can arise. If a company loses money, that is, if its taxable income is negative, it can ask for a refund of taxes it has paid in recent years. That’s great for the company, but if it is new and has never paid taxes, a refund isn’t possible. Instead, it hangs onto the potential tax refund for use in the future. Accountants call them “deferred tax benefits” rather than “potential refunds.” If the company eventually does better and ends up with some taxable income, it can offset the tax it owes that year by drawing on the deferred tax benefits it has accumulated.

Because these benefits are valuable for reducing future tax payments, they are considered an asset. So, they are added to any deferred tax asset that has arisen due to timing differences, as discussed above.

Using Tax Assets

This is what Sirius XM Canada has been doing. In 2016, it had taxable income of over $60 million. This was its best year ever, by far. Tax owed on this taxable income came to almost $11 million. But the company didn’t have to pay a dime, because at the end of 2015, it had accumulated tax losses from previous years totalling $133 million, well more than the $60 million of taxable income for 2016.

These accumulated tax losses gave the company a deferred tax asset worth over $19 million heading into 2016. After deducting the $11 million in taxes for 2016, the company was therefore still sitting on $8.5 million in deferred tax assets.*

Here is a table of the company’s accumulated tax losses and its net tax asset from 2011, when the company was formed, until 2016 when it went private:

Summary of tax losses.png

As usual, I’m listing the years in reverse order, because that is how they appear on the company’s financial statements. This table confirms what I said above, that at the end of 2016, the company still had a considerable amount of accumulated tax losses to apply to future taxable income, and those losses were worth $8.5 million. This is the amount of income tax it can avoid in future years.

But the table also shows us something shocking. The brand new company, just formed in 2010, had $490 in accumulated tax losses coming out of the gate. But we know from the 2011 income statement that it had a profit of almost $18 million that year. Where did the tax losses come from?

Merger Mania

They came from the two companies that merged in 2010. XM Radio’s parent company, Canadian Satellite Radio Holdings, brought $371 million in accumulated tax losses with it into the merger. The rest came from Sirius Satellite Radio Canada.

Here’s the thing. Those tax losses combined were worth over $50 million in 2011, but in 2010, before the companies merged, they were worthless. Don’t just take my word for it. Look the final annual report issued by CSRH, just before the merger:

 Tax losses for Canadian Satellite Radio Holdings prior to merger

Tax losses for Canadian Satellite Radio Holdings prior to merger

How can these tax losses be worth nothing?

Very simple, actually. The tax losses are only worth something if the company expects to earn a profit in the future. Up until 2010, CSRH was losing money and had no prospect of getting out of the red. Accounting regulations don’t allow a company to list an asset that isn’t actually going to provide any financial benefits. So the company had to declare that its tax losses were worthless.

For you accounting buffs out there, the term for this is a “valuation allowance.” Just like an allowance for doubtful accounts is used to reduce the total money owed by customers down to the amount that is likely to be collected, a valuation allowance is used to reduce the deferred tax asset down to the amount of future taxes that are likely to be avoided. In the case of CSRH, zero.

The merger changed all this. With a monopoly, the new company had every expectation of earning profits. It would be able to use all the tax losses from the two merging companies to reduce its future tax bills for quite some time.

The merged company happily took the tax assets from CSRH and Sirius Satellite Radio Canada, and discarded the valuation allowances. That’s how the tax asset went from a value of zero on CSRH’s last balance sheet to $51 million on the first balance sheet of Sirius XM Canada.

Magic.

Is this fair?

The case of Sirius XM Canada raises some important questions. Should companies be allowed to pay dividends to shareholders before paying income tax? How can we ensure corporate taxes are collected when money can so easily be transferred out of the country, or between one corporation and the corporations that own its shares?

These are practical questions. Governments wrestle with them constantly. And corporations lobby governments incessantly with advice, some of it even solicited.

But there is an even bigger question here, and that is about the role of corporations in society. What are corporations for, and what should we expect of them?

We too easily accept the idea that corporations are merely an economic engine, designed to maximize profit. I would argue that corporations are actually much more important than this. They are one of the important places where we generate meaning in our society, through meaningful work and meaningful products.

Our expectations of corporations are far too limited. We expect too little of them, not too much.



* Shortly after its 2016 year end, Sirius XM Canada went private. So, we will never know for sure what happens to the rest of this asset. However, we can be pretty sure it will be used by the company this year, if it has taxable income.


Photos of Raj Rajeshwari Temple taken in Kathmandu in 2014. Something about tax losses being reincarnated as tax assets, I guess.