Rohan Arora, Mo Iqbal, Rajat Majumdar, and Chris Vickers
The company that pays 0.1% Tax
Air Canada is the largest airline in Canada and earns the majority of its revenue from passenger air transport. According to Air Canada’s financial statements, the company has been earning revenue since 2011, and their revenue has been steadily increasing at approximately 5% per year. However, despite having earned significant income the company has paid almost no tax since 2011. The following graph shows this anomaly between net income and taxes paid by Air Canada.
To unravel this anomaly, the tax section of the 2015 and 2016 annual reports for Air Canada were examined and in both cases indicated the net taxes payable was written off using what they call “recognition of previously unrecognized deferred income tax asset.” An interesting point about this write off is seen in the reduction of income taxes it causes, as it always exactly matches the net income taxes payable. Thinking about how this is possible raises some questions like: where is this asset coming from, how is it valued, and how are they recognizing it? The next interesting point is that despite being called an asset in the income taxes section of the annual report, it is not listed on the balance sheet. So why would they be treating an asset like this, excluding it from the balance sheet, even though it is clearly making a material difference in their taxes each year.
Since 2011, the total net income of Air Canada was $1.4 billion and yet during this same five year period the company has paid only $2 million to the CRA. That’s a tax percentage of 0.1%, compared to the average statutory tax rate of 26.97%. Additionally, the carry forward losses the company incurred in 2011, of $70 million, are not nearly enough to cover the amount of taxes the company has written down. So, where exactly is this income tax reduction coming from?
Tax Anomaly Explained
In order to understand where the “Recognition of previously unrecognized deferred income tax asset” comes from, we went back through the company’s previous financial statements until the asset first appeared. This first appearance was in 2011, which happens to coincide with the year that Air Canada implemented the new accounting practices from IFRS.
Once we established that the asset was created in 2011, the next step was to figure out where it came from. It was evident, after going through the balance sheet, that the values listed were fairly consistent from year to year, with the exception of the pension and benefits liability. This figure jumped from $3.3 billion to $5.5 billion, which is interesting because an increase of $2.2 billion in just one year is unusual.
Whenever something unusual occurs, it is often explained in the Management Discussion and Analysis (MD&A) section of the Annual report, as was the case for this increase. According to the MD&A, it was the result of a decrease in the discount rate, used to determine the future value of the pension and benefits obligation.
What is a discount rate?
To better understand this, let’s consider what a pension and benefits liability is. In order to meet the future obligation of paying employees pensions, a sum of money will need to be set aside now. This amount of money will be discounted based upon the interest that is earned on existing payments. This interest rate is known as the discount rate.
In terms of accrual accounting two accounts will result, the first is the future obligation to employees (liability) and the second is the amount of money that is set aside to cover this future obligation (asset). If there is more money in the asset account to cover this obligation than needed, the net difference will show up as a net asset, and conversely the account will show up as a net liability if the obligation exceeds the asset.
So, where did the rest of the change come from?
After looking at the pension and other benefit liabilities section of the 2011 financial statement, it was discovered that there was some truth to what the MD&A said, but it didn’t tell the whole story. The discount rate did indeed fall from 2010 to 2011 from 5.5% to 5.2% respectively. However, the change in the benefit obligation on the liability side of the equation, which can be attributed to the discount rate, only increased by $958 million, where the total change was $2,237 million.
If the full net change in the pension and benefit liability didn’t come from a decrease in the discount rate, then where did it come from? This is when the major insight into this story happens – the minimum funding liability. The additional minimum funding liability went from $321 million to $1,965 million, from 2010 to 2011 respectively and represents an increase of $1,644 million. If we subtract the $365 million increase in the assets, then we arrive at $2,237 million, which accounts for the total increase experienced by the liability.
The next part of the story has to do with accrual accounting, and the fact that we need to balance the credit we have from this net liability, with a debit somewhere else. The debit is, effectively, going to show up as an expense at some point. There are several options, however, as to when we recognize this expense. It can be placed into income and recognized as an expense now, or listed under other comprehensive income (OCI) and recognized later.
Accrual accounting – Here’s where things get tricky
Since in accrual accounting, performance of assets like pension and benefits is not related to the performance of the company, it can be attributed to OCI. This is exactly what Air Canada does, as we see an increase in the OCI minimum funding liability account from negative $1,639 million to positive $1,645 million from 2010 to 2011. Once these expenses are placed in OCI, they can be recognized at a later date.
When the company has to draw on its assets, and pay off a portion of the pension and benefits, then they are going to recognize that portion of OCI by crediting the OCI account, and debiting an expense account. So, in effect, the management can decide what portion of the liability will be recognized in OCI each year. This makes the OCI account, in essence, a reservoir of future expenses.
Air Canada is using this expense reservoir to reduce their expenses each year. Although this is not as straightforward as it sounds, as reducing the pension and benefits account involves a lot of accruals since these payments are not necessarily cash. In other words, the amount of expenses that they recognize each year is not the same as the amount they actually pay out in pension benefits. Therefore, we have a pile of expenses that are being recognized for which there is no cash payment.
The tax department doesn’t allow tax deductions that are not cash, which gives rise to a difference between the accounting income and taxable income. Air Canada is only allowed to deduct the actual payments they made to the recipients of benefits, according to the CRA. This leads to a higher taxable net income than shown on the company’s income statement, which causes the company to pay more tax each year. To put this another way, revenue minus expenses is equal to taxable income, and one of the expenses is pension and benefits. However, this expense is not an actual payment, it’s an obligation that reduces the taxable income on the income statement, but not the tax payment. This means in the future they are able to pay less taxes, which creates a temporary difference; a portion of which resolves each year in the form of a tax benefit. Each year Air Canada has been drawing on this expense in order to eliminate the amount of taxes that are supposed to be paid.
This gives rise to more questions as its unusual for managers to understate the assets, and reduce the appearance of the financial health of the company.
Tax Asset Transparency
So, why would this tax benefit not be shown as a tax asset on Air Canada’s balance sheet?
This is mysterious considering the company is drawing on this asset to write off their taxes each year. One theory is that Air Canada may want to under represent their assets, thus placing the company’s position in a worse light, and thereby reducing their obligation to pay hefty dividends to shareholders.
Further, Air Canada may want to under represent their assets so that unions will have less leverage during salary negotiations. This theory is supported by a recent article posted in CBC that stated: “Air Canada, which has been involved in bitter and continuing labour problems over the past year with its pilots, mechanics, flight attendants and ground crews, has quite a valid reason to avoid a pay conflict with the unions."
One final theory for this lack of transparency may be a limitation of the IFRS standard. Specifically, IAS 19, the parent standard of IFRIC 14, states that the tax assets from pension plans listed on a company’s balance sheet have an upper limit. This just may be an accounting limitation.
About the Authors
Rohan Arora is a first year MBA Candidate at the Schulich School of Business and is passionate about technology. He has over four years of experience working as a software developer with IT firms in India.
Mohammad Iqbal is a first-year MBA candidate at the Schulich School of Business specializing in consulting and finance. He holds a Bachelor of Applied Science in Mechatronics Engineering from the University of Waterloo and he has over 8 years of experience in Systems Engineering.
Rajat Majumdar is a first-year MBA candidate at Schulich School of Business. He has six years of work experience in Power Plant commissioning and operations.
Christopher Vickers is a first-year MBA candidate at the Schulich School of Business, specializing in finance and business and sustainability. He holds a Bachelors of Science degree in chemistry from the University of Guelph, and has 4 years of experience working in pharmaceuticals.
Air Canada 2016 Annual Report.
Image is from the cover of this report.