Last August, the Canadian National Exhibition in Toronto brought us the cronut burger, a croissant-doughnut-burger hybrid that left fair-goers with a upset stomachs. This year, there's an even bigger burger doughnut combo and its effects are equally as uncertain – that is, if the proposed takeover of Tim Hortons Inc. by Burger King Worldwide Inc. proves to be of net benefit to Canada under the Investment Canada Act.
The net benefit to Canada test is the metric by which the federal government evaluates all international purchases of Canadian companies above a certain size. On one hand, the test makes a tremendous amount of sense. For a variety of reasons, Canadian companies are easy targets as there is little they can do to defend against opportunistic or coercive takeover bids and, therefore, foreign investment should be placed under scrutiny to avoid the so-called "hollowing out" of Corporate Canada. On the other, critics point out that the net benefit to Canada test is an opaque standard and there is little clear guidance to its application.
To evaluate whether a transaction is of net benefit to Canada, the industry minister will ask how a transaction or investment will affect economic activity in the country, the amount of Canadian participation in the transaction, the effects of the investment on domestic and international productivity, and, most ambiguously, whether the transaction is compatible with Canadian industrial, economic and cultural policies.
While these criteria may seem straightforward, the minister refuses to give a specific weighting to each factor, leaving the approval process somewhat mysterious.
Of course, there are things that acquiring companies can do to help their chances of approval. One of those things is that an acquirer can move its headquarters to Canada. Relocation both shows that a company is serious about the Canadian market and explicitly addresses questions of Canadian participation in the transaction.
Burger King, in its acquisition of Tim Hortons, is quite prominently doing just that. Most of the analysis of Burger King's relocation to Canada has focused on the supposed tax benefits of such relocation and, undoubtedly, there are tax benefits to the move.
It's worth clarifying what those benefits are. U.S. tax rules are somewhat unique and, in the opinion of many, unfair to companies with large worldwide operations. While companies located in most countries, including Canada, pay domestic corporate taxes on their domestic revenue but the foreign corporate tax rates on their foreign income, U.S. rules force companies to pay American rates on all worldwide income brought back stateside. While companies receive a credit for the foreign tax they pay, they still have to pay the balance to the Internal Revenue Service. This encourages companies to keep large amounts of income overseas in order to defer U.S. taxation.
So, not including provincial and state corporate taxes, if Burger King wants to bring Canadian revenue stateside to distribute it to shareholders, it has to pay an additional 20 per cent of its income to the IRS – the difference between the 15-per-cent Canadian and 35-per-cent U.S. federal rates. If it relocates to Canada, Burger King does not have this problem, but it still has to pay 35 per cent of its U.S. income.
In other words, when Barack Obama chastises companies for using tax inversions to avoid their patriotic duty to pay U.S. taxes, he's really chastising companies for avoiding their duty to pay U.S. taxes on their foreign income. Somehow, that seems slightly less un-American.
Still, as others have pointed out, the tax inversion reasons for this deal seem less compelling than for other companies that can divert much larger portions of their revenue to low-tax jurisdictions (and Canada's 15 per cent is much higher than, say, zero per cent in the Cayman Islands). Burger King has little foreign cash sitting in accounts and most of its operations are in North America. In addition, company filings show that Burger King managed to get its U.S. tax rate down to 27.5 per cent while it paid 26.8 per cent in Canada. Finally, some Burger King shareholders will be forced to pay tax on their exchange of shares from the old entity into the new one due to the limited availability of the partnership units that allow shareholders to defer taxation on exchange. All in all, relocation to Canada offers a relatively small tax benefit for a potentially large public relations backlash.
This means that it's useful to think about other reasons why Burger King is locating to Canada, and this brings us back to the net benefit to Canada test.
In their presentation to investors, Burger King and Tim Hortons draw attention to the strategic benefits of the transaction. They focus on the ability of the joint company to accelerate Tim Hortons's international growth and to accelerate Burger King's growth. These synergies seem substantial, but aren't enough to get the deal through the Investments Canada Act.
Burger King will retain Tim Hortons' Canadian identity, including its support of minor hockey. But most important, the company will be located in Canada. That probably all but guarantees that the deal will be approved. The idea of four out of five cups of Canadian coffee being purchased from a U.S. company would have been the corporate version of Edmonton selling Wayne Gretzky to the Los Angeles Kings, not an experience this country would like to relive.
However, it's not as though moving to Canada is an easy PR strategy. Bad press in the U.S. can scuttle a deal if there aren't compelling business reasons behind it; just ask Walgreen Co.
All of this is to say that while there are tax benefits to this deal, we shouldn't be so characteristically modest. Avoiding U.S. taxes matters but, if Burger King and Tim Horton's think the deal makes real economic sense for the businesses of both companies then Canadian law matters too. And, if relocation to Canada is what Canadian law requires to assure a good deal gets done, then relocation to Canada will happen.
In short, relocation to Canada is the free coffee in your Tims sandwich combo. It's what encourages you to buy. The tax benefits are the doughnut. It's not essential to the meal, and it may get you some flak from your doctor, but it tastes so good going down.