Letter Decision No. LET-R-33-2019

SUMMARY

CN argues that the current approach to apportion debt to its Canadian balance sheet is likely to overstate long-term debt, and has proposed an alternative methodology. The Agency finds that CN’s contention regarding the overstatement of debt is likely true and that a different approach may be required, but that CN has not provided sufficient information for a proper assessment of the alternative methodology it proposes.

The Agency is therefore considering the application of a methodology based on revenue ton miles (RTM) as an interim approach for the 2019-2020 crop year, while it invites and assesses additional submissions by CN on the alternative methodology it has proposed.

BACKGROUND

In August 2017 and on May 24, 2018, CN requested that the Agency re-consider how it determines CN’s CoC rate as part of the Volume Related Composite Price Index (VRCPI) process. The CoC rate is an input into the VRCPI and all cost-based regulatory determinations. CN specifically requested that the Agency consider the use of a North American-based approach or, in the absence of that, suggest how CN might apportion its reported debt between its Canadian and American  operations.

In Determination No. R-2018-225 the Agency noted that “While the CoC rate is an important input used in determining the VRCPI, it is determined as part of a separate Agency regulatory process and, as such, the Agency will address CN’s request as part of that process and outside of this Determination.”

On February 12, 2019, as part of its 2019-2020 CoC submission, CN proposed a North American-based approach to determining its capital structure.

CURRENT PRACTICE

Currently, CN’s parent company, which is headquartered in Canada, holds CN’s long-term debt on its books. This long-term debt is used to finance both CN’s American and Canadian operations.

In Decision No. 125-R-1997, the Agency addressed the appropriate amount of debt to attribute to CN’s regulatory balance sheet (RBS), which is the balance sheet determined in accordance with the Uniform Classification of Accounts and Related Railway Records (UCA) and which forms the basis of CoC determinations. . In that Decision, the Agency found that “using the corporate long-term debt reduced by the identifiable non-rail long-term debt is appropriate in assessing CN’s long-term debt for cost of capital purposes.” Debt is considered part of CN’s RBS unless CN can prove that the debt was raised for a specific non-rail purpose, or to finance  American operations. Each debt instrument is assigned either 100% to Canadian rail operations, partially to Canadian rail operations, or excluded from Canadian rail operations.

CN’S SUBMISSION

CN argues that “the past BS [balance sheet] presentation that shows a ratio of long-term debt (LTD) to shareholders equity (SHE) of 170% is just not credible for a corporation that maintains an A credit rating.”

CN submits that “UCA account 65 [Long-Term Debt] has shown a zero balance for years, since all of the LTD has been lent to US operations and therefore shows up in the UCA of Canadian operations in UCA account 87 (Net investments in rail assets).”

CN proposes to replace the current methodology of allocating specific debt instruments between jurisdictions with a methodology that would “allocate the debt such that the LTD/SHE ratio for the Canadian operations is the same as for the entire corporation”.

ANALYSIS AND FINDINGS

The Agency agrees with CN that the proportion of its debt considered to be Canadian is likely overstated for regulatory purposes. However, CN’s submission lacked sufficient documentary evidence and analysis for the Agency to properly assess its proposed methodology.

In particular, this proposed methodology does not take into consideration differences in the accounting basis between the UCA and CN’s consolidated financial statements. These differences are particularly evident in the case of property accounting. For example, CN’s consolidated financial statements (see note 19 from the 2018 full year financial statements) indicate that CN has properties in Canada with a net investment of nearly $20 billion. However, CN’s RBS indicates net investment in property is just over $13 billion.

Because of these accounting differences, using CN’s proposed methodology may not reflect the true financing requirements for the net rail asset investment (as defined in Determination No. R‑2017‑198). Based on CN’s proposed methodology, only 38% of CN’s long-term debt would be allocated to its RBS. Given that the long-term debt is raised for general corporate purposes, the Agency would expect to see an allocation that is more in line with the scope of CN’s operations in Canada. Of note, CN earned more than two thirds of its revenue in Canada in 2018 and has 2.3 employees in Canada for every employee it has in the U.S.A.

CN’s proposed methodology would be a significant departure from past regulatory practice as it would ignore the long-standing reliance on the UCA as the framework for regulatory accounting. CN has not explained the link among CN’s consolidated balance sheet, its Canadian parent company’s balance sheet and its RBS. As well, CN did not submit evidence to support its claim that “all of the LTD has been lent to US operations” resulting in a zero balance in UCA 65.

A more complete record and thorough examination of the relationship between CN’s Canadian balance sheet and CN’s RBS is required before a final determination can be made.

REVIEW PROCESS

In order to properly examine CN’s proposed methodology, the Agency will launch an additional review process. The information reviewed through this process will inform a decision on the methodology to be applied to the apportionment of CN’s long-term debt for CN CoC determinations beginning with the 2020-2021 crop year.

DIRECTION ON REVIEW PROCESS

The Agency directs CN to provide to the Agency the following information by May 1, 2019:

1. a detailed reconciliation between CN’s parent company’s audited balance sheet and the F1 in the annual report filed with Transport Canada for the past three years (2016, 2017 and 2018). In the case of the 2018 reconciliation, if the finalized version of the F1 is not available, a reconciliation to the preliminary F1 is acceptable; and
2. supporting documents and/or explanations of the differences reconciled.

In addition, a site visit from Agency staff may be required to verify the information submitted by CN.

INTERIM APPROACH – THE RTM METHODOLOGY

In order to correct for the likely overstatement of long-term debt on CN’s balance sheet, the Agency is considering, as an interim approach for the 2019-2020 crop year, the adoption of a methodology based on RTMs. An RTM is the movement of one ton of revenue traffic over one mile. The RTM methodology would allocate general purpose debt to CN’s RBS based on the proportion of CN’s total RTMs that are performed in Canada. The methodology ensures that the allocation of CN’s long-term debt to its RBS is closely tied to the scope of CN’s operations in Canada. The RTM approach alters the current practice of allocating specific debt instruments as follows:

1. any long-term debt that can be allocated specifically between the two jurisdictions would continue to be allocated in such a manner; and
2. all general purpose debt would be allocated to the RBS based on the proportion of CN’s RTM’s in Canada in the year in which the debt instrument was issued.

DIRECTION ON INTERIM APPROACH

CN may submit comments to the Agency on the interim approach by April 5, 2019.