Target Canada's interlocking relationships

Going back to the Pre-Filing Report submitted by Target Canada's imminent Monitor, here are some interesting aspects as to how an organization like that is structured.

Banking

Four banks were involved:

• Royal Bank of Canada
• Toronto-Dominion Bank
• JPMorgan Chase
• Bank of America

 Bank of America was the prime banker, into and out of which all funds ultimately flowed:

• CAD credit, debit and gift card transactions flowed through deposit-taking accounts at TD, which were swept into concentration accounts.
• Other CAD and USD  receipts flowed through deposit-taking accounts at RBC, which were swept into their respective concentration accounts.
• Funds from TD and RBC were transferred to the Bank of America on an "as needed" basis, in order to fund Target Canada's operations.
• There was an account at JPM dedicated to overseas vendor payments, which was funded out of the Bank of America.
• Bank of America handled all disbursements through several accounts (segregate according to method of payment and currency type), which were swept into concentration accounts. There was also a master account for currency conversion and funding JPM payments, as well as an account dedicated to payments to Starbucks under its licensing agreement for in-store sales.

There is nothing unusual about such arrangements - in fact, I first came across similar structures in the early 1980s, and they were very effective then in managing complex series of transactions. It is interesting, though, that the Canadian banks played an essentially subordinate role here.

Intercompany agreements

There was a master agreement in effect between Target Canada and one of the Target US operating subsidiaries that covered an extremely broad range of support services as well as a license for Target's intellectual property. The support staff were located at Target's head office in Minneapolis, as well as in India. It's interesting to observe that they were only in the process of obtaining approval from the CRA for an advance pricing agreement to assure that fees payable under the APA would be regarded as being at arm's-length. After over two years, one would think that such approval would have already been received.

There were also intercompany agreements in effect for the secondment of employees from Target US operations to Target Canada, where connected expenses were reimbursed, as well as for the management of its leased properties, its buying agency, and its design and development services.

All of these arrangements are quite normal in multinational companies, and they should be used more in Canadian-owned enterprises. That may tie in with the hollowing-out effect I mentioned previously.

Thoughts on capital investment appraisal

A while back, I posted about the techniques one must use when calculating appraisals in a Canadian context. It was somewhat simplified, as it pertained only to a single alternative. That is unrealistic, as the business world is more complex: 

• What if there are alternatives?
• Which one makes more economic sense?
• Assuming that benefits are equal among the alternatives, which project results in the lowest cost?
• What if these alternatives have different economic lives?
• Is leasing or buying the most economical choice?

For the first two questions, the answer is almost always the alternative with the greatest net present value on a discounted cash flow basis. The only plausible exception is where the project represents a major ground-breaking development, and that calls for strategic decision-making at the Board level. That is a discussion for another time.

For the other questions, there is a technique available that has been rarely discussed but is quite powerful, which calls for determining the Equivalent Annual Cost. Put simply, it is the net present value divided by the capital annuity factor, or

$ EAC = \frac{NPV}{A_{t,i}} $

where t = number of years, and i = cost of capital. The capital annuity factor is calculated as:

$ A_{t,i} = \frac{1-\left(\frac{1}{1+i}\right)^t}{i} $

If there is any salvage value at the end of the project, that can be factored in through using a sinking fund factor, calculated as:

 $ SFF_{t,i} = \frac{1}{\left(1+i\right)^t-1} $

This is useful for many scenarios:

• What if the asset requires periodic overhauls every few years, and in what circumstances is it cheaper to replace rather than overhaul?
• What commitments must be made for maintaining inventories of parts and maintenance supplies?
• What if a landlord provides rent-free periods at certain points in the lease?
• Are there conditional grants or other incentives that are paid subsequent to acquisition or improvement of an asset?
• Can the asset be sold at the end of its useful economic life, and would that value be different for the various alternatives?

These can be calculated in a rather straightforward manner. Let us take an example of deciding which of two types of storage tanks would represent a more economical investment. A steel tank costing CAD 10,000 with a salvage value of CAD 1,000 and annual operating costs of CAD 1,600 has an estimated useful life of five years. It is being compared to a stainless steel tank costing CAD 25,000 with a salvage value of CAD 2,000 and annual operating costs of CAD 100. Which is the better choice?



In this case, all other things being equal, the stainless steel tank has the lower EAC, and it should be the preferred choice.

For manufacturing and processing operations, assets fall under class 29, which has a different calculation. The result can be modified as follows:



 In this case, the end result would still be the same, but note how different the NPVs are for the capital investment.

This is not a new technique: in fact, it was taught to all CMAs and still represents part of the Body of Knowledge that we are expected to use in our work. It was discussed in much greater detail in A Practical Approach to the Appraisal of Capital Expenditures (C. Geoffrey Edge, V. Bruce Irvine (1981), ISBN 0-920212-29-8), which, having been last issued in 1989, does not seem to be widely available these days. I took one of its examples on this subject, and updated it to take into account the "half-year rule" now in effect for claiming first-year CCA, as well as more realistic rates for corporate tax and cost of capital. Otherwise, the logic is still sound.

I am publishing this because I cannot seem to find anything similar on the web, and this is just too useful not to attract a wider audience in the CPA community. Formulas are embedded, so that its working can be better understood.

Another sad point about Target Canada

Normally, reviewing bankruptcy and CCAA filings is rather depressing, but there are occasions where some details pop out that really are surprising.

Take the recent news about Target pulling the plug on its Canadian operations:



There's a throw-away observation on p. 16 of the Pre-Filing Report, which disclosed that "[Target Canada] does not have stand-alone accounting and treasury departments." These functions were handled out of Target's head office in Minneapolis, under an intercompany agreement.

Think about it: in establishing its Canadian operation, the US parent decided that it was not appropriate to set up a separate Finance function, whether for reasons of cost or operational efficiency. I have already been familiar with some larger companies setting up shared service centres for consolidating some aspects of their operations world-wide, but deciding to farm out the entire function to another country does not bode well for us CPAs here. This is suggesting a hollowing-out may be coming for many Canadian operations of foreign companies, on a scale we have not yet contemplated:

• spreadsheet and ERP applications have taken over many tasks that used to be consigned to clerical staff
• receivables and payables processing can be fully automated, to the point that remittance information can be transmitted to vendors for posting directly against outstanding invoices without human intervention
• banking transactions can be handled in similar fashion
• in short, paper-based transactions are essentially obsolete, and any that remain suggest that operations are not being competently managed
• posting and reconciliation can be handled anywhere, and I am already familiar with such operations being handled out of India, Malaysia and the Philippines by equally competent staff working for significantly less salary that would be the case here

Given these realities, what is left for professional accountants to do on our home turf? Is there still opportunity for developing Finance groups with a critical mass of CPAs that will benefit new Canadian organizations that are not in the public sector? This is definitely worth debating.

Fair market value or not?

Probably the most succinct definition I have ever seen in this matter can be found in the UK's Value Added Tax Act 1994, in which it is declared:

"the open market value of a supply of goods or services shall be taken to be the amount that would fall to be taken as its value ... if the supply were for such consideration in money as would be payable by a person standing in no such relationship with any person as would affect that consideration."

 Therefore, the value must be expressed in money, as determined on an arm's-length basis. In most circumstances that will not be a problem, but watch out for the exceptions:

• What if the item is being provided in exchange for another good or service, with or without money being paid?
• What if the item is being supplied being related parties, and is thus not at arm's length?

The first issue is directly relevant to barter and trade-ins, on which the CRA has issued Interpretation Bulletin IT-490 to cover related income tax issues, and GST memorandum GST-300-7 for GST/HST issues. These are definitely worth reviewing, as:

• assets may need to identified as capital, inventory or otherwise,
• the transaction could trigger either income or capital gain or loss,
• the item on one side could be taxable for GST/HST purposes, whereas the other side could be exempt.

These are just the basic questions.

The second issue is even more complex:

• While certain related parties have been deemed by statute to not operate at arm's length (eg, those related by "blood, marriage or adoption"), there are still circumstances where parties otherwise unrelated are still so closely connected that the courts would consider them not to be at arm's length as well.
• The exchange of goods and services in such circumstances can never be for nil consideration, except under very restricted circumstances by way of election.
• S. 69 of the Income Tax Act requires such transactions to be undertaken at fair market value. To enforce this, it has a severe penalty: the party that provides the supply at an undervalue will be deemed to have disposed of it at FMV, while the receiver can only record its cost at the amount it actually paid for it. In that regard, it has been held that a promise to pay the difference cannot be accepted, unless it is in the form of a mortgage or demand note.
• This consequence can be mitigated in the case of property being transferred by taxpayers to a qualifying Canadian corporation under s. 85, where the consideration must include shares of the corporation. By filing form T2057, both parties are able to fix a value that falls anywhere between FMV and a specified floor value for the property in question, but only if the form is filed within a specified time.
• Because of multiple cross-border issues that may arise (the most notable of which are transfer pricing and non-resident withholding tax), all non-arm's-length transactions with non-residents must be reported annually to the CRA on form T106.

There are other possibilities, but I have outlined the very basic ones that people in business need to know.

How then to mitigate your exposure to any adverse moves from the CRA? The following should be basic measures:

• All transactions should be recorded, with ones in the normal course of business being properly invoiced, and extraordinary ones being the subject of a written agreement.
• You should normally price transactions the same way you would do for your better customers for the same product or service. However, there are transactions that will not occur with outside parties that will need to be addressed.
• The CRA encourages businesses to enter into an Advance Pricing Agreements to cover issues arising from cross-border transactions with non-resident parties not at arm's length. The underlying concepts for these are sound, and similar work should be undertaken for pricing domestic transactions.
• For the disposal of property that is not a normal supply of a good or service, such as the transfer of real estate, plant equipment or an entire operation, a proper valuation will be required. That can be an expensive proposition as CBVs do not come cheap.
• Be sure to record any shares that were issued, and make doubly sure that any debts are properly secured through the appropriate registrations and other formalities.
• Settle intercompany debts on a regular basis, and do not roll them over into shareholder loans. Failure to do so on cross-border transactions could trigger deemed dividends with related withholding tax obligations.
• Be sure to get all of this appropriately reviewed by your lawyer and CPA, xxx, especially before it gets past the point of no return.
• Keep all documentation that occurred at the time of the transaction! Contemporaneous files will always carry greater weight, and the courts always seem to be skeptical of work that is undertaken after the fact.

Once that is done, everything will almost appear to be easy in comparison.

Dealing with the US? You can run, but you can't hide...

The landscape has changed these last few years in doing business in the States. It used to be taken for granted that, if you kept all your operations stationed in Canada, you never really had to worry about any complications that may arise with respect to US law. There may have been some legal issues, but they could be reasonably managed.

These days, those propositions are not sure things. The United States has been extending its reach, and the various states have been doing likewise in other respects. Here are a few items to take note:

Pre-emptive tax filing with the IRS for foreign corporations

A recent newsletter from BDO summarizes the tax position quite well:

• A non-resident—whether an individual or corporation—is subject to U.S. federal tax if they have income that is “effectively connected with the conduct of a trade or business within the United States.” The threshold for what constitutes "trade or business" is quite low, as even making sales calls to customers for soliciting orders, or shipping product to the US where title will pass there, will qualify.
• The Canada-US tax treaty will generally protect such income from being taxed by the IRS if it is not attributable to a "permanent establishment" as defined by that treaty. However, US law requires a foreign corporation to file form 1120-F (US Income Tax Return of a Foreign Corporation), together with form 8833 (Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)), in order to claim such treaty protection. Individuals would need to file form 1040NR (US Nonresident Alien Income Tax Return) or 1040NR-EZ (US Income Tax Return for Certain Nonresident Aliens With No Dependents) plus form 8833 to claim similar protection. If not filed, you will be taxed on your gross income. Penalties and interest will apply if these forms are late-filed, even where you claim protection.
•  US customers are now required to confirm that you qualify as either a US or foreign person through filing any of forms W-8BEN, W-8ECI, W-8IMY or W-8EXP (depending on your situation). Failure to file could result in a 30% withholding tax on any payments to you, but the appropriate return can be used to claim back improper withholdings.
• In order to file any of these forms, you will require a Social Security Number or Individual Tax Identification Number or, for corporations, an Employer Identification Number.
• Reporting obligations generally begin once eligible activity occurs.

The message is quite clear: in order to claim protection, you have to prove your existence. Once the IRS knows you exist, you will then be on their radar.

There are other implications:

• The various states have even more aggressive rules for determining taxable income, and they are not bound by the tax treaty. Many of them have rules governing taxation of part-year residents (ie, taxing based on the days in the year in which you may have been in the state earning subject income), which does not exist in Canadian provinces. This is an area where you will really need professional help.
• For Canadian-controlled private corporations, income attributable to foreign sources will not be eligible for the Canadian small business deduction.

Permanent filing requirements for "US persons"

Of course, it could be worse: if you are a US citizen or green card holder, you have to file every year, no matter where you live in the world. Even if you are not, you are still required to file as a resident alien where:

• you have been in the US for 183 days or more in a given year, or
• you have been there for at least 31 days that year, and that number, plus 1/3 of such days the year before, and 1/6 of such days the year before that equal 183 or more (but there are exceptions), or
• you are a nonresident alien spouse of a resident alien who has elected to file jointly.

On the other hand, if you can claim a closer connection to another country, or a tax treaty applies to your circumstances, you may still be able to avoid resident alien status. However, you still need to file the appropriate forms to take advantage of the rules, and filing as a nonresident alien may still be required.

The rules concerning corporations are somewhat clearer: if it is formed under the law of any US jurisdiction, it is a US person. If it is formed outside the US, it is a foreign person. There is no residency or control test that would override this. The distinction makes a difference, as a US person is subject to tax on worldwide income, while a foreign corporation could face taxation on what was earned within the US. There are, however, complications that will arise in both scenarios that are too numerous to list here.

Are you employing a "US person"?

This is a serious question, and the IRS has asserted since 1992 that, if you are employing a US citizen or resident alien anywhere in the world, you are actually obliged to deduct US federal income tax from any related pay. This is subject to two important caveats:

• Such wages are not subject to US federal income tax withholding to the extent that such wages are already subject to the income tax withholding of a foreign country.This effectively means that, under the Canada-US tax treaty, income earned in Canada would be subject to Canadian taxes, but income earned outside Canada may be caught (subject to any treaties the US may have with other jurisdictions).
• Subject individuals may otherwise be entitled to a foreign earned income exclusion (worth USD 97,900 in 2014), but they must file Form 673 (Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusions Provided by Section 911) with their employer in order to reduce any applicable source deductions.

If you have any significant dealings with the US, you might need to review your payroll procedures, as the IRS is really becoming serious in enforcing this. Cathay Pacific announced this year that they were starting to make such deductions, which affected 18% of their cockpit crew. This may have something to do with ensuring that they keep their landing rights in the States.

Of course, if you have anyone working on United States soil—no matter what their status—you are obliged to deduct and remit the appropriate amounts to the appropriate jurisdictions. That's perfectly fair—after all, Canada asserts the same rule for anyone working here, whether the workers are residents or nonresidents.

The long arm of US jurisdiction

Taxation is not the only area in which you should be concerned with being caught up with United States jurisdiction. There is significant regulatory and legal exposure for actions you pursue outside their borders:

• In the 1950s, Eaton's was sued for violating US trademark law under the Lanham Act (Vanity Fair Mills, Inc. v. T. Eaton Co., 234 F. 2d 633 (2d Cir. 1956)). The suit was dismissed, but the court declared that extraterritorial jurisdiction was possible in certain circumstances.
• In 2011, a Chinese company was barred from exporting its products to the US, because it had ripped off certain trade secrets of an American manufacturer in violation of the Economic Espionage Act of 1996 (Tianrui Group Company Limited LLC v International Trade Commission, 661 F.3d 1322 (Fed. Cir. 2011)).
• There's also a catch-all provision in the US Criminal Code about making false statements, under which the Feds have been securing many convictions (for which Martha Stewart comes to mind), so be careful in answering any queries arising from investigations being undertaken. This is a separate offence from that relating to filing false returns under taxation laws.

Again, if you employ a "US person":

• Let's not forget the amazing reach of the International Traffic in Arms Regulations, which regulate any export, re-export and deemed export of arms and technology between "US persons" and "foreign person," no matter where they are in the world. Canadian companies enjoy some relief due to a bilateral agreement, but there are still some very real barriers to be aware of.
• They are subject to US economic sanctions, which can affect dealings occurring outside the country, especially with respect to funds transfers and transportation of goods.

The upshot

Be very careful, and investigate what you are getting yourself into, when you are dealing with US customers and suppliers, and with the American market in general. It's a different world down there!

What is a consultant?

It's amazing how many businesspeople do not contemplate the implications of this question. There have been too many times where I have heard some managers say, "If you don't want to be on payroll, why don't you work as a consultant?"

This is wrong on so many levels, as it concentrates on form rather than substance, and it sees the matter as a tax question rather than one of justifiable necessity for the business. We must understand the different types of workplace relationships that exist, and the differences that exist between them:

• employee (whether full- or part-time),
• officer,
• director,
• agent,
• partner,
• independent contractor, and
• consultant.

Beginning at the end of the list, probably the best definition of what a consultant does can be found in this model clause I've come across. It's from the US, and the wording could be tightened up, but it does convey the general idea:

 It is understood that the purpose of the Consulting is to provide periodic review and advice relevant to certain Company matters, and that neither Consultant nor Company will benefit if Consultant provides inaccurate advice or commentary based on insufficient information. To that end, Company shall provide Consultant, in advance of meetings, with accurate, unbiased and sufficient information for him to review the subject matter thereof, and shall promptly provide further information that Consultant reasonably deems relevant to forming any pertinent conclusions relevant to the matter for discussion. It is expressly understood that Consultant has no fiduciary obligation to Company, but instead a contractual one described by the terms of this Agreement; that Consultant’s role is to provide independent advice uninfluenced by commercial concerns; and that service as a Consultant does not require him to be an advocate for Company or its products in any forum, public or private. Company expressly agrees that under no circumstances will this role be compromised or inaccurately represented.

 In short, a consultant is called upon:

• to review and advise on specified issues,
• to expect complete cooperation from the client in obtaining the information needed to accomplish the task,
• to be independent in his approach, and
• not to be an advocate for the client.

Notice as well that this type of relationship means that he is not:

• an employee, as his output is not subject to the client's control.
• an officer or director, as he does not have the capacity to make decisions that directly affect the client.
• an agent, as he does not have the capacity to bind the client.
• a partner, as he does not have the ability to share in any gains or losses from the client's activities.
• an independent contractor charged with the responsibility to provide a specific deliverable beyond his reports.

Our CMA training provided us with the capacity to assess strategic issues within a broad context, which directly ties in to this area. Our professional training has also included business management experience, so we can also step into more active roles, should our subsequent client engagements call for such moves. I am ready to help provide success in all such aspects.

We're all in this together now...

After so many decades, the way is clear for Canada's three accounting bodies to merge into one! As usual, Ontario was the last to agree (there's a lot of history behind that, as I have alluded to in previous posts). The various provincial legislatures will be passing the appropriate legislation this fall, once they return after Thanksgiving this October. Quebec, New Brunswick, Saskatchewan and Bermuda have already done so, and British Columbia has taken the interim step of recognizing the new designation (with amalgamation of the bodies to follow). Ontario took a unique route, as I described previously.

The various squabbles that have divided us for so long remind me of what has been said about university academic politics, which are so vicious because the stakes are so small! When pressed to describe what has made each of us so distinct, most of us have had a hard time putting it into words that would be helpful to someone outside the profession. I think the best description was found in a bad joke from the 1980s:

"CGAs do great books, CMAs tell you the truth about what happened, and CAs bend it all to fit generally accepted accounting principles."

That, of course, was said in jest, but it does describe the three basic approaches that figure in accounting education: financial statement preparation, operational analysis and external reporting. All else flows from these three core components.

We still have a lot to do to educate others as to what we are truly capable of. Job descriptions that call for a professional designation with knowledge of QuickBooks (as I have seen on numerous occasions) are definitely off the mark. QuickBooks, as well as Simply Accounting, can be performed by someone with a high school course in bookkeeping, while someone with a professional designation would be called upon to review the work. However, the ability to review is subject to any public accounting licensing restrictions that may be in effect in that jurisdiction.

In a similar vein, I have also seen job positions that call for a degree and designation in order to hold a Financial Analyst role. FA positions are a great training ground while you are studying for your designation, but a severe underuse of capabilities upon graduation.

Quite frankly, those with professional designations have been trained to hold management positions within the organization. Private companies whose owners ignore that fact will be severely constraining their capabilities. Public companies are more aware, but the smaller ones still need to be given the message.

Let's see what the future holds. Bring it on.