Income taxes

9 Months Ended

Sep. 30, 2023

Income Tax Disclosure [Abstract]

Income taxes

Income taxes

During the three months ended September 30, 2023, legislation was enacted to decrease the Iowa and Arkansas state corporate income tax rates. As a result of these changes, the Company recorded a deferred tax recovery of $14 million related to the revaluation of deferred income tax balances.

During the three months ended September 30, 2022, legislation was enacted to decrease the Iowa state corporate income tax rate. As a result of this change, the Company recorded a deferred tax recovery of $12 million related to the revaluation of deferred income tax balances.

The effective tax rates including discrete items for the three and nine months ended September 30, 2023 were 24.88% and 166.83%, respectively, compared to 18.01% and 18.97%, respectively for the same periods of 2022.

For the three months ended September 30, 2023, the effective tax rate was 24.96%, excluding the discrete items of amortization of business acquisition fair value adjustments of $87 million, acquisition-related costs incurred by CPKC of $24 million, a tax settlement with the Servicio de Administración Tributaria ("SAT”) (Mexican tax authority) in relation to taxation years for which audits have closed and an estimated reserve for potential future audit settlements totaling $15 million (see further discussion within the Mexican Tax Audits section below), and a deferred tax recovery of $14 million on state corporate income tax rate changes as mentioned above.

For the three months ended September 30, 2022, the effective tax rate was 24.25%, excluding the discrete items of the equity earnings of KCS of $221 million, acquisition-related costs incurred by CPKC of $18 million, a deferred tax recovery of $12 million on state corporate income tax rate changes as mentioned above, and an outside basis deferred tax recovery of $9 million arising from the difference between the carrying amount of CPKC's investment in KCS for financial reporting and the underlying tax basis of this investment.

For the nine months ended September 30, 2023, the effective tax rate was 24.91%, excluding the discrete items of the reversal of the deferred tax liability on the outside basis difference of the investment in KCS of $7,832 million upon acquiring control (see Note 8), remeasurement loss of KCS of $7,175 million (see Note 8), the equity earnings of KCS of $230 million, amortization of business acquisition fair value adjustments of $162 million, acquisition-related costs incurred by CPKC of $158 million, revaluation of deferred income tax balances on unitary state apportionment changes of $51 million, an outside basis deferred tax recovery of $23 million arising from the difference between the carrying amount of CPKC's investment in KCS for financial reporting and the underlying tax basis of this investment, a tax settlement with the SAT in relation to taxation years for which audits have closed and an estimated settlement for potential future audit settlements totaling $15 million (see further discussion

within Mexican Tax Audits section below), and a deferred tax recovery of $14 million on state corporate income tax rate changes as mentioned above.

For the nine months ended September 30, 2022, the effective tax rate was 24.25%, excluding the discrete items of the equity earnings of KCS of $627 million, acquisition-related costs incurred by CPKC of $57 million, a deferred tax recovery of $12 million on state corporate income tax rate changes as mentioned above, and an outside basis deferred tax expense of $8 million arising from the difference between the carrying amount of CPKC's investment in KCS for financial reporting and the underlying tax basis of this investment.

Mexican Tax Audits

Kansas City Southern de México, S.A. de C.V. (also known as Canadian Pacific Kansas City Mexico) ("CPKCM") closed audit examinations with the SAT for the tax years 2016-2020 in September 2023. The audit examinations were for corporate income tax and value added tax (“VAT”). The settlement of these audits resulted in a payment of $75 million in September and a $16 million reduction to the April 14, 2023 refundable VAT balance, which was classified within "Accounts receivable, net". The settlements primarily resulted in an increase to "Goodwill" (see Note 8) and an "Income tax expense" of $9 million. The estimated impact of potential future audit settlements were substantially reserved as of September 30, 2023, which included a reduction to the April 14, 2023 VAT balance of $9 million and an income tax expense of $6 million.

Mexican Value Added Tax

CPKCM is not required to charge its customers VAT on international import or export transportation services, which prior to 2022 resulted in CPKCM paying more VAT on its expenses than it collected from customers. These excess VAT payments are refundable by the Mexican government. Prior to 2019, Mexican companies could offset their monthly refundable VAT balance with other tax obligations. In January 2019, Mexican tax reform eliminated the ability to offset other tax obligations with refundable VAT. From 2019 through 2021, CPKCM generated a refundable VAT balance and filed refund claims with the SAT, which have not been fully recovered or settled.

In November 2021, changes to the VAT law were announced and became effective beginning January 1, 2022. These changes reduced the recoverability of VAT paid by CPKCM on its expenditures that support international import transportation service revenues that are not subject to a VAT charge. VAT that is unrecoverable from the Mexican government results in incremental VAT expense for CPKCM. Beginning in 2022, CPKCM changed certain service offerings to either require VAT to be charged to customers on revenue, or impose a rate increase to offset the incremental VAT expense. These measures implemented by CPKCM increased the VAT collected from customers and payable to the Mexican government.

As of September 30, 2023 and April 14, 2023, the CPKCM refundable VAT balance was $10 million and $55 million, respectively. There was a $25 million reduction to the April 14, 2023 VAT balance as a result of the Mexican Tax Audit settlements as discussed above. The settlement resulted in impacts to "Goodwill" (see Note 8) and the refundable VAT balance at April 14, 2023. CPKCM has prior favourable Mexican court decisions and a legal opinion supporting its right under Mexican law to recover the refundable VAT balance from the Mexican government and believes the VAT to be fully recoverable. CPKCM expects to recover the refundable VAT balance as VAT billed to customers exceeds creditable VAT charged by vendors.