Reflections on a long-gone enterprise

It's funny when you dig up some old pictures, and it makes you reflect on the events that led up to it, no matter how innocuous it may appear to be. The above image is a perfect example, taken of the back side of a business that had been recently shut down at the time.

There are apparently five shipping doors, consisting of three loading docks and two drive-in bays. However, only two of them were functionally available, being the two left-hand docks. Why was the operation constricted to only 40% of its potential shipping/receiving capacity? The first clue pops out when you take a closer look at the driveway under bay 3:



You have to look a bit closely, but there are spikes of rebar sticking out of the concrete, which served to secure a large dumpster that was seemingly always stationed under the bay door.

Bay 4's door was integrated into a large cardboard compactor that was inside, and thus could not be opened at all. In addition, a significant amount of garbage was left outside, which was one of the reasons the space between bays 4 and 5 was cluttered:



From the colour of the asphalt, it is readily apparently that the dust collection system inside (which was piped through a hole bored through the door next to bay 5) was not very efficient in collecting particulate matter, which engendered a completely different round of issues.

Between bays 4 and 5, a concrete pad was placed into the asphalt, on which an external dust collection system was mounted:




The bollards were steel tubes driven into the asphalt, into which concrete was poured. There was a secondary concrete pad poured between the first pad and the building.

The worst damage of all is seen at bay 5:



In this area are bollards, remnants of the same, as well as rebar punched into the asphalt. The upside-down T-bar at the top of the door also served to restrict the height of whatever could enter the building. In addition, there was a sorting line just inside the door, which prevented most equipment from being able to enter in any case. The shelter just in front of the door, which was used by maintenance staff for doing some outside work, did not help either.

The building had to be returned to the landlord at the end of its lease, which was only months away. The lease had a standard term, under which it had to be returned in the condition existing at the beginning of the term, and the changes undertaken by the tenant without the landlord's consent (including the above), known as "dilapidations", had to be removed. I was hired to help monitor the activity that needed to be done to fix all this. There was other work that needed to be done inside, but that is another story altogether!

The bay doors had to either repaired or replaced, to bring them back to working order. The asphalt in the back required substantial replacement, and the contractors really went to town on that:



And it really felt good to see the finished result:



But it does beg many questions as to what led to such a poorly designed system such as this. Several factors are quite apparent:

• The building is ideally designed to function as a warehouse. However, the business was oriented towards manufacturing, which has its own unique requirements.
• The business was being strangled by its waste collection system. The driveways on either side leading to the front of the building were very narrow, and thus any collection equipment could not be installed there. In addition, no thought was ever focused on using the space between bays 4 and 5 more efficiently with equipment positioned directly on the wall.
• With logistical capacity at only 40% of what it could have been, material flows both into and out of the facility were needlessly restricted. This had knock-on effects all down the line, which led to the loss of significant contracts with major customers arising from the inability to provide timely shipments.

There were other issues as well, and the industry in question was going through major shifts at the time, but I think the above were at the core of what was going on.

The latest federal Budget and capital investment

I haven't seen any good summaries on this topic on any of the standard websites, so here is my take on certain aspects of interest to management accountants.

Moving away from Class 29 CCA in 2016

This is rather interesting, in that the new Class 53 for manufacturing and processing equipment (effective for acquisitons after 2015 and before 2025) will be effective for at least ten years, at a 50% declining-balance amortization rate for the pool of assets concerned. This is a bit less attractive than the 25%-50%-25% amortization over a three-year period, but somewhat easier to calculate. Why they chose to move from the one method to the other is still not clear.

Why is it less attractive? It all comes down to simple math and standard capital investment appraisal techniques. For purposes of discussion, let us assume a gross investment (C) of CAD 100,000, a cost of capital (i) of 10%, and a combined federal/Ontario marginal tax rate (t) of 25% (ie, net of manufacturing and processing profits deductions).

The net present value after tax for investing in Class 29 assets is calculated using the formula

$ I \left [ 1-t\left (\frac{0.25}{1+i}+\frac{0.5}{\left (1+i\right)^2}+\frac{0.25}{\left (1+i\right)^3}\right) \right ] $

or approximately CAD 79,282.

Now let's take a look at the new Class 53, with its amortization rate (d) of 50%, subject to the half-year rule. The net present value after tax for that investment would be calculated using the formula

$ I \left [ 1-\left (\frac{td}{i+d}\right )\left (\frac{1+\frac{1}{2}i}{1+i}\right ) \right ] $

 or approximately CAD 80,113, which would an effective cost increase of about 1%.

The feds still maintain that the eventual fallback classification for such assets, for acquisitions after 2025, will be Class 43 at a rate of 30%. As they have been deferring this move for several years now, it remains to be seen whether it will ever come about, but the above formula would then suggest a net after-tax cost of about CAD 82,102, or 3.6% above the Class 29 amount.

The differences are not huge, and Canada's rates for such investments are still probably some of the most generous in the world. The real challenge will be getting Canadian managers to undertake any investment at all, which invites further discussion on our appetite for undertaking significant expansion and innovation. To date, there has been too much emphasis on improving the concessions for small businesses, but it has been argued that such measures constitute a disincentive for expansion, as too much activity is expended towards keeping such enterprises below the thresholds for applying higher rates, thereby limiting cash flows available for productive investments. That, however, is an argument for another day.

Integration of Eligible Capital Property within the CCA system

There will apparently be legislative proposals later on this year to deal with this matter, which will be quite welcome. It's been a long time coming for this idea to come about for getting rid of what was essentially a parallel régime. I look forward to seeing what the detailed measures will entail.

How will you cope under "cap and trade"?

This week's news that Ontario and Quebec will set up a joint "cap and trade" scheme to control carbon emissions is interesting, although lacking in such important information as details. I would have preferred the "carbon tax" option that BC has chosen, as it would be administratively simpler to run, but businesses here will now have to get ready for it. I foresee that we accountants, but more importantly the engineers, will need to really work in order to ensure that this works the way it is intended to.

Here's why:

• The businesses that will be subject to the scheme will have to self-report the amount of carbon emissions that they generate. Whether this is based on inputs or outputs, it means some rather detailed manufacturing reporting, and that's where the engineers will need to set up the appropriate systems.
• Businesses will be issued permits assigning given carbon allowances for what they are allowed to consume. Depending on the scheme's design, some permits may be given out for free, while others may be issued upon payment of a given price per tonne of carbon emissions involved. It you emit less carbon than you are permitted, you can sell the excess allowances on the open market. If you emit more carbon than you have allowances for, you will be assessed a fine, unless you purchase other businesses' excess allowances. That is where the accountants come in, to keep track of the company's exposure and ensure that everything is being properly reported.
• Over time, the amount of carbon allowances will be proportionately reduced, in order to compel reductions in the generation of emissions.

There are accordingly several risks and opportunities:

•  Who will qualify for free allowances?
• Will the scheme cover all emitters, or will certain exemptions or minimum thresholds apply?
• How efficiently will the open market for excess allowances work?
• As emissions caps are being progressively reduced, will it be cheaper to invest in new equipment in order to meet the targets, or will it be cheaper to pay the fines?
• Would it be worth your while to invest in new equipment now, if the market price for your excess allowances will generate a positive net present value?
• Similar concerns arise about the financial viability of investing in carbon offset projects and other methods of securing credits.

Quebec's scheme is interesting to look at, but Ontario has refused to indicate whether theirs will function the same. Stay tuned in six months' time.

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.