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CRA has been revisiting the tax filings of several former income trusts because of how they applied tax losses acquired from other companies. Some companies have decided to settle with the taxman, while others have chosen to fight. Advisors should focus on who might be next and what the potential impact is on valuation.

Tax losses are valuable because they allow companies to reduce future taxable income when they’re profitable. A company may sell its tax losses if it does not think it will be able to use the losses before they expire. Normally, companies aren’t allowed to use the tax losses of companies in unrelated businesses. For instance, an energy company can’t purchase tax losses from an airline. Let’s look at an example. Superior Plus Corp., an energy services, chemicals and construction products business, is in the process of fighting CRA over its acquisition of $800 million in tax losses from Ballard Power Systems, a long-time money-losing maker of fuel cell technology.

The deal was done in 2008, as part of a complicated plan through which Superior Plus also converted to a corporation. Ballard received $46 million for its tax losses.

The two companies were in different industries, so the only reason Superior Plus attempted the manoeuver was because it used to be an income trust. The rules had never explicitly denied the practice for trusts like they do for corporations.

But CRA tends to frown on such loopholes, especially if they lead to potential tax avoidance.

Who might be next?

There have been settlements with 20 or so former income trusts that started to receive reassessment notices as far back as 2013 (see “Who has settled with the taxman?” below). That number will continue to increase and, combined with what seem like reasonable settlement terms, advisors need to question companies that are digging in for a fight based on a tax loophole that touches on tax avoidance.

There are a number of trusts that pursued strategies, back in the heyday of corporate re-conversions, that were similar to those used by companies that have already settled with CRA. And the CRA seems to be slowly working through a list (notices have been sent out regularly over the past two years) of those trusts.

Based on our analysis, we have identified two companies that may be next. They are by no means the only possibilities, and they might not even receive a reassessment notice from CRA, but they seem to fit the now-familiar profile.

Energy company Total Energy Services acquired tax shields of approximately $150 million from Biomerge Industries, a medical imaging company, for $4 million in 2009. Likewise, Premium Brands, a food company, picked up roughly $250 million in tax benefits from Thallion Pharmaceuticals, also in 2009.

Caveat: To our knowledge, CRA hasn’t won a case based on its stance, and the companies objecting to reassessments may win their cases in the end (which could be three years from now, given the current pace of tax court cases).

Investment perspective

Is it better for advisors to assume a settlement will happen for valuation purposes? That’s the position we’ve taken with oil firm Baytex Energy, which acquired tax losses from various entities in 2010. In determining our target price for the stock, we’ve written off the value of the tax losses to the tune of $262 million, despite the company appealing the ruling and issuing the statement that it will “vigorously defend its tax filing position.”

We have taken a similar stance with Algonquin Power, a utility firm. Algonquin disclosed that it received a notice of reassessment in February 2015, and that CRA would re-examine its filings for the years 2009 to 2013. The company decided to appeal the ruling, and “vigorously defend” its position.

Algonquin had originally purchased about $200 million of tax losses from Hydrogenics, a fuel cell maker. Algonquin notes that, if it eventually loses its argument regarding the use of acquired tax losses, it would refile its returns to use other accumulated tax losses. This way, the company would not be in a net owing position for the years in question.

From an investment perspective, we think it’s best to assume the losses are worthless. This viewpoint is conservative but, more importantly, reasonable given the spate of settlements announced by other companies (despite the original vigorous defense mounted by some).

Who has settled with the taxman?

There are a number of former trusts that have settled with CRA recently, due to tax filings from 2008 and 2009 (leading up to the requirement to convert to corporations in 2011).

Here’s a look at a few.

Exchange Income Corp. settled with CRA in February 2015, after initially trying to fight the reassessment of its tax returns. EIC purchased roughly $275 million in tax losses from Harmony Airways in June 2009, also as part of its conversion to a corporation. The settlement did not result in any cash outlay. CRA dropped its claims to back taxes, and EIC agreed to write down the value of the tax losses.

Meanwhile, in October 2014, food distributor Colabor Group also agreed to write down the value of its acquired tax losses, while not needing to pay any additional taxes for prior periods. Colabor had paid ConjuChem Biotech $5 million for roughly $100 million of tax losses back in 2009.

Ag Growth (a maker of grain-handling equipment) agreed to similar terms, based on its use of previously acquired losses. Ag originally fought the reassessment, but then decided not to proceed in what would’ve likely been a prolonged fight.

Cervus Equipment Corp., a manager of farm equipment dealerships, is the latest to raise the white flag. It settled with CRA in May 2015 over its acquisition of more than $200 million in tax losses from Vasogen in 2009 for $8 million.

Dr. Al Rosen, Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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