MAKING THE RIGHT CONNECTIONS 2 0 1 5 A N N U A L R E P O R T Contents 1 A message from the Chairman 2 A message from Claude Mongeau 4 Making the right connections Connecting with partners Connecting with customers Connecting with employees Connecting with communities 8 Board of Directors 9 Financial Section (U.S. GAAP) 91 Corporate Governance – Delivering Responsibly 92 Shareholder and Investor Information Except where otherwise indicated, all financial information reflected in this document is expressed in Canadian dollars and determined on the basis of United States generally accepted accounting princi- ples (U.S. GAAP). Certain information included in this annual report constitutes “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, these forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the outlook or any future results or performance implied by such statements. Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions, industry competition, inflation, currency and interest rate fluctuations, changes in fuel prices, legislative and/or regulatory developments, compliance with environmental laws and regulations, actions by regulators, various events which could disrupt operations, including natural events such as severe weather, droughts, floods and earthquakes, labor negotiations and disruptions, environmental claims, uncertainties of investigations, proceedings or other types of claims and litigation, risks and liabilities arising from derailments, and other risks detailed from time to time in reports filed by CN with securities regulators in Canada and the United States. Reference should be made to “Manage- ment’s Discussion and Analysis” in CN’s annual and interim reports, Annual Information Form and Form 40-F filed with Canadian and U.S. securities regulators, available on CN’s website (www.cn.ca), for a summary of major risks. CN assumes no obligation to update or revise forward-looking statements to reflect future events, changes in circum- stances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that state- ment, related matters, or any other forward-looking statement. As used herein, the word “Company” or “CN” means, as the context requires, Canadian National Railway Company and/ or its subsidiaries. A message from the Chairman Dear fellow shareholders 2015 was the 20th anniver- sary of CN’s highly successful IPO. We should all have a deep sense of pride and accomplish- ment in all that has been achieved in the past 20 years. This last year confirms the depth and strength of CN at all levels to deal with unforeseen challenges while continuing to create value for our customers and shareholders. After many years of growth, the slowdown in the economy forced CN to shift its focus and show again how nimble it could be when volumes were down. Another unexpected situation for CN was the health challenge that our CEO Claude Mongeau faced in the later part of the year as he recovered from throat surgery and radiation treatment. During his absence, our CFO Luc Jobin and the CN Leadership Team stepped up and stayed connected with our employees, stakeholders and each other to ensure that CN stayed the course. The Board appreciates their dedication and commitment, and indeed that of the entire team of nearly 25,000 employees, for maintaining CN’s role as the leading railroad in the industry. CN is more than just a great railroad; it’s a great company. CN was acknowledged for its achievements in many areas that are meaningful measures of how we contribute to society. Indeed, we were recognized in the Globe and Mail’s annual review of Corporate Governance in Canada, where CN ranked 5th overall, and 1st in its industrial group. Our sustainability practices earned CN a place on the Dow Jones Sustainability World Index (DJSI) for the fourth consecutive year, and the Company has been listed on the DJSI North America Index for seven years in a row. Among CN’s many contributions to support stronger and safer communities throughout our serving territory in North America, perhaps the most significant in 2015 was our $5-million donation to assist with the resettlement of Syrian refugees across Canada. This contribution speaks to our history as a company that moved immigrants and refugees from Pier 21 in Halifax by rail across the country to build Canada as we know it today. CN is a responsible and engaged company that strives to strengthen its connections with all stakeholders, including communities, customers, shareholders and employees. We are very proud of all CN achieved in 2015. We were very pleased to welcome Claude back to his duties in January 2016. With Claude’s outstanding leadership and the strong team behind him, we are confident CN can keep delivering in its role as a backbone of the economy that continues to make the right connections. Sincerely, Robert Pace, D.COMM. Chairman of the Board CN | 2015 Annual Report 1 A message from Claude Mongeau MAKING THE RIGHT CONNECTIONS Dear fellow shareholders One of CN’s hallmarks has been the ability to accommodate growth with low incremental cost. With the economic slowdown and the first drop in CN volumes in many years, we faced a different kind of challenge in 2015, one we reacted to with great agility and effectiveness. As the slowdown became apparent, we recognized the need to adjust, and we quickly gained traction in realigning our resources in line with a lower volume environment. To see an organization of our size and magnitude be this nimble is a testament to our teamwork and the result of a common understanding of our business agenda. We worked diligently to contain costs, and that included making some tough decisions. We adjusted our hiring activities and our train starts, and as a result, we implemented some layoffs in areas where the volume of traffic had declined more significantly. In as many cases as we could, we offered affected employees opportunities to work in other functions. Our efforts allowed us to deliver solid results in difficult circumstances. CN’s full- year 2015 adjusted diluted EPS increased 18 per cent, with reported 2015 net income of $3,538 million versus $3,167 million in 2014. We continued to balance Operational and Service Excellence, driving operating metrics up by a significant margin while improving key service metrics at the same time. The operating ratio was 58.2 per cent in 2015, an improvement of 3.7 points over the 2014 level of 61.9 per cent. “ To see an organization of our size and magnitude be this nimble is a testament to our teamwork and the result of a common understanding of our business agenda.” In terms of improved performance, there is no area more important to us than safety. Our commitment to a safe and fluid network and to a culture that promotes safety is unrelenting. Connecting with our employees on safety remains a top priority. During the year, we further embedded our Looking Out For Each Other initiative, based on peer-to-peer safety communications, with modern field training for the majority of our work force. Our safety results in 2015 showed major improvements in terms of both accidents and injuries. 2 CN | 2015 Annual Report “ In 2015, CN commemorated the 20th anniversary of its privatization, a key milestone in our remarkable transformation journey to a leadership position in the industry.” In 2015, CN commemorated the 20th anniversary of its privatization, a key milestone in our remarkable transformation journey to a leadership position in the industry. This moment of true pride was an opportunity to celebrate, but also a call to reflect on what lies ahead as we continue to build for the future. In tackling the challenge of staying at the top of an industry where we have been a long-time leader, CN realized that an opportunity to raise our game could be found in how we connect amongst ourselves and with external stakeholders. Our success in these efforts was brought home to me in a personal way during my recovery from surgery and radiation therapy. In addition to being touched by the thousands of messages I received from employees who reached out to me with kind words of support, I was energized to see the tremendous teamwork of our railroaders pulling together to serve customers safely and efficiently. I realized that something special unites us in our desire to ensure CN fully plays its role, and that renewed my deep pride and my determination to continue leading this great company. Indeed, as we prepare for the future, I note the important initiatives we took in 2015 to best position us for the challenges, including stepping up our efforts to connect with supply chain partners, customers, and communities. For example, CN strengthened its connections with ports and Intermodal terminal operators by signing supply chain agreements with the Port of Mobile, Alabama State Port Authority, and APM Terminals, as well as with the Port of New Orleans. These collaboration commitments are expected to drive container traffic through the Ports and across CN’s network, further reinforcing CN as a key player on the U.S. Gulf Coast. A significant step in connecting with communities in 2015 was the introduction by the rail industry and by CN of the AskRail mobile app, allowing first responders to access real- time information about the contents of rail cars located in their jurisdictions. By the end of the year, over 1,500 first responders along CN’s network had downloaded the AskRail app. We are making great strides in our employee engagement programs as well, including promoting sustainability in areas such as energy conservation and waste reduction. CN’s From the Ground Up program supports the greening of municipal properties in communities along our rail lines. With over 1.2 million trees and shrubs planted in Canada and the U.S., CN is the leading private non-forestry company tree planter in Canada. Our connection with customers is at the core of our strategic agenda. One at a time, across our network, we know that if our customers win, we win as well. A common pursuit of sustainable and profitable business growth in a market-driven environment brings benefits to all and drives economic prosperity. All of these CN connections are intertwined. Understanding and improving how they all work together helps the Company continue to provide value that distinguishes us from our competitors and helps us retain our position as an industry leader. Claude Mongeau President and CEO CN | 2015 Annual Report 3 MAKING THE RIGHT CONNECTIONS Connecting with partners A round trip box brings Company, for the last haul to efficiency full circle Indianapolis for unloading. Rather Innovation and customer service are than send back empty containers the hallmarks of CN’s business. The to the West Coast on the return, Company’s great franchise allows it CN has collaborated with other to offer a wide range of integrated customers and terminal operators to partnerships, including ports, maximize the use of the assets. In facilities, regional railroads, transload one case, empty containers are sent centres and distribution centres. to a major brewing company where But it is CN’s unique supply chain they are loaded with beer for the approach that is redefining the way western Canadian consumer market. it connects with customers, suppliers After delivery in Western Canada, and other partners to deliver quality CN collaborates with the steamship and efficient end-to-end service. lines and exporters to reload the One example is CN’s trans- containers with products like por tation solution for Asian pulp, paper and agricultural goods containerized imports arriving destined for Asia via CN’s West at the Ports of Vancouver and Coast Gateway connections. Prince Rupert in British Columbia. CN’s efficient approach is CN’s Supply Chain Collaboration the result of daily engagement, Agreements with the Port information sharing, problem solving, Authorities means U.S.-bound and precise execution that connects containers are unloaded from the partners at every link of the supply ships and assembled in blocks for chain. It provides solutions to help transport to Chicago within a customers win in the marketplace 48-72 hour timeframe. and defines CN’s role as a true Some of the containers are supply chain enabler. moved by rail to outside Chicago where they are transferred to CN’s partner carrier, the Indiana Railroad 4 CN | 2015 Annual Report Connecting with customers Reaching new markets After helping Kingsbury win in its Whether large multi-nationals or market through domestic expansion smaller businesses, CN strives to with traditional hopper cars, CN help every customer succeed. One is enabling customers to capitalize example is family-owned Kingsbury on opportunities in new overseas Elevator Inc., which relies on CN markets with Intermodal containers. to bring inbound grain products The initiative facilitates the export of from the U.S. and Western Canada soybeans to Asian markets through to its facility in the Midwest. The CN’s Intermodal site in Harvey, IL. Company transloads and trucks the Kingsbury is a great example of livestock feed products to local dairy connecting with our customers at farms. Until recently, the facility, multiple points on the supply chain. which is served by a train that When it comes to providing switches off CN’s main line between customized solutions, CN’s long list Kirk Yard, IN, and Battle Creek, MI, of services includes warehousing and could only load or unload 3 cars at a distribution, industrial development time. But with unused property, and for new rail-served sites or to expand high demand for speciality grains from Canada, Kingsbury had strong existing ones, customs brokerage service, CargoFlo® and bulk-handling growth potential. facilities, and state-of-the-art CN invested in infrastructure logistics parks, among others. to partner with Kingsbury on an With continued demand for expansion, and help evolve the North American products in Asia, business from a limited operation to CN is leveraging its full suite of a much larger-scale one, growing services to help customers win in its volumes to over 1,000 carloads established and new markets, which a year. Seeing further growth is the best way in turn for CN to win. potential, Kingsbury built a new storage and warehouse facility, including an underground pit system to unload cars. CN | 2015 Annual Report 5 MAKING THE RIGHT CONNECTIONS Connecting with employees Safety first collaborative relationships with its CN’s connections with employees are union partners to improve employee central to having a skilled, safe and retention, safety and engagement. engaged workforce. Real-time tracking of issues with a Safety is of the utmost importance groundbreaking Grievance tracking at CN. The Company connects system allows all involved to better employees to this core value by manage workplace disputes, identify fostering a strong safety culture emerging trends and focus training across the network. Training is at and education for maximum benefit. the heart of that culture. CN’s major In addition, CN works to contin- investment in two training facilities in uously connect employees to the Winnipeg, MB, and Homewood, IL, wider world in which we operate is revitalizing the way it teaches and by encouraging environmental reinforcing strong safety behaviours. stewardship in its yards, buildings and Among other things, employees offices through CN EcoConnexions. learn about the valuable role peer-to- CN promotes inclusion and tolerance peer communications, coaching and in the workplace, including significant mentoring all play in safe railroading. efforts to attract and hire individuals In 2015, over 16,500 Mechanical, from all walks of life and to support Engineering, Transportation and diversity through sponsorship, Intermodal employees received scholarship and internship programs. focused training on what we call CN offers training that introduces Looking Out For Each Other. This is employees to different cultures and about a mindset which encourages fosters respectful and sustainable employees to imbed safety in their relationships with a variety of daily practices in order to ensure communities across the Company’s everyone goes home safely at the network. end of the day. Additional efforts to connect with CN’s workforce include fostering 6 CN | 2015 Annual Report Connecting with communities Stronger ties Community program, which provides CN is actively engaged in building grants each year to hundreds of the safer, stronger communities through charities where they give of their time. the direct connections it makes CN’s connection with the with them. Responsible investments Aboriginal community is an important in development, donations and area of focus. Examples include CN’s sponsorships and open, positive five-year sponsorship of an annual community outreach programs are week-long “Pulling Together” canoe the foundation of CN’s commitment. event. CN was also a lead corporate One of the best ways CN supports sponsor of the Mississaugas of the communities is to help ensure New Credit First Nation during the healthy and active lives for children 2015 Pan Am/Parapan Am Games in and their families. The CN Miracle Toronto, Ontario. Match program has raised more than Supporting municipalities in their $12 million for children’s hospitals work, CN was a sponsor of the across Canada and the United States Federation of Canadian Municipalities since its inception in 2006. Annual General Meeting in 2015, Youth-oriented support has also as well as its annual Sustainable involved linking with Prairie farmers Communities Conference. at the Canadian Western Agribition To help build safer communities, in Regina, SK. On that occasion, CN CN Police are active in teaching announced a national partnership good public rail-safety behaviours in with 4H Canada, the country’s schools and at community events. biggest rural youth association, CN continues to deliver on its to advance community leadership Structured Community Engagement and promote rural safety. Plan with hundreds of fire chiefs, Connecting with their own mayors and city managers across the communities to help make them better network to share information about places to live and work is a reason why the transportation of dangerous so many CN employees and retirees goods, in addition to supporting volunteer. CN supports their efforts training for thousands of emergency through the CN Railroaders in the response personnel every year. CN | 2015 Annual Report 7 Board of Directors As at December 31, 2015 Robert Pace, D.Comm. Chairman of the Board Canadian National Railway Company President and Chief Executive Officer The Pace Group Committees: 3, 4, 5, 7 Edith E. Holiday Corporate Director and Trustee, Former General Counsel, United States Treasury Department and Secretary of the Cabinet The White House Committees: 1, 2, 6, 7, 8* Claude Mongeau President and Chief Executive Officer Canadian National Railway Company Committees: 4*, 7 Donald J. Carty, O.C., LL.D. Retired Vice-Chairman and Chief Financial Officer Dell, Inc. Committees: 1*, 3, 5, 6, 7 Ambassador Gordon D. Giffin Partner Dentons US LLP Committees: 1, 4, 6*, 7, 8 V. Maureen Kempston Darkes, O.C., D.Comm., LL.D. Retired Group Vice-President General Motors Corporation and President GM Latin America, Africa and Middle East Committees: 1, 2, 3, 5*, 7 The Honourable Denis Losier, P.C., LL.D., C.M. Retired President and Chief Executive Officer Assumption Life Committees: 3*, 4, 6, 7, 8 The Honourable Kevin G. Lynch, P.C., O.C., PH.D., LL.D. Vice-Chair BMO Financial Group Committees: 2*, 3, 6, 7, 8 James E. O’Connor Retired Chairman and CEO Republic Services, Inc. Committees: 1, 2, 5, 6, 7* Robert L. Phillips President R.L. Phillips Investments Inc. Committees: 1, 3, 5, 6, 7 Laura Stein Executive Vice-President, General Counsel The Clorox Company Committees: 1, 2, 5, 6, 7 Committees: 1 Audit 2 Finance 3 Corporate governance and nominating 4 Donations and sponsorships 5 Environment, safety and security 6 Human resources and compensation 7 Strategic planning 8 Investment committee of CN’s Pension Trust Funds * denotes chair of the committee Chairman of the Board and Select Senior Officers of the Company As at December 31, 2015 Robert Pace Chairman of the Board Claude Mongeau President and Chief Executive Officer Kimberly A. Madigan Vice-President Human Resources Russell J. Hiscock President and Chief Executive Officer CN Investment Division Sean Finn Executive Vice-President Corporate Services and Chief Legal Officer Luc Jobin Executive Vice-President and Chief Financial Officer Jean-Jacques Ruest Executive Vice-President and Chief Marketing Officer Jim Vena Executive Vice-President and Chief Operating Officer Mike Cory Senior Vice-President Western Region John Orr Senior Vice-President Southern Region Janet Drysdale Vice-President Investor Relations Michael Farkouh Vice-President Eastern Region 8 CN | 2015 Annual Report Financial Section (U.S. GAAP) Contents 10 Selected Railroad Statistics – unaudited Consolidated Financial Statements Management’s Discussion and Analysis 11 Business profile 11 Corporate organization 11 Strategy overview 14 Forward-looking statements 14 Financial outlook 15 Financial highlights 15 2015 compared to 2014 16 Adjusted performance measures 16 Constant currency 17 Revenues 21 Operating expenses 22 Other income and expenses 22 2014 compared to 2013 54 Management’s Report on Internal Control over Financial Reporting 54 Report of Independent Registered Public Accounting Firm 55 Report of Independent Registered Public Accounting Firm 56 Consolidated Statements of Income 56 Consolidated Statements of Comprehensive Income 57 Consolidated Balance Sheets 58 Consolidated Statements of Changes in Shareholders’ Equity 59 Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements 60 1 | Summary of significant accounting policies 26 Summary of quarterly financial data 63 2 | Recent accounting pronouncements 26 Summary of fourth quarter 2015 27 Financial position 28 Liquidity and capital resources 33 Off balance sheet arrangements 33 Outstanding share data 33 Financial instruments 64 3 | Other income 65 4 | Income taxes 66 5 | Earnings per share 66 6 | Accounts receivable 67 7 | Properties 67 8 | Intangible and other assets 36 Recent accounting pronouncements 67 9 | Accounts payable and other 37 Critical accounting estimates 68 10 | Long-term debt 44 Business risks 53 Controls and procedures 70 11 | Other liabilities and deferred credits 70 12 | Pensions and other postretirement benefits 77 13 | Share capital 78 14 | Stock-based compensation 83 15 | Accumulated other comprehensive loss 84 16 | Major commitments and contingencies 88 17 | Financial instruments 90 18 | Segmented information 90 19 | Subsequent event CN | 2015 Annual Report 9 Selected Railroad Statistics – unaudited Financial Key financial performance indicators Total revenues ($ millions) Rail freight revenues ($ millions) Operating income ($ millions) Net income ($ millions) Diluted earnings per share ($) Adjusted diluted earnings per share ($) (1) Free cash flow ($ millions) (2) Gross property additions ($ millions) Share repurchases ($ millions) Dividends per share ($) Financial position Total assets ($ millions) (3) Total liabilities ($ millions) (3) Shareholders’ equity ($ millions) Financial ratios Operating ratio (%) Adjusted debt-to-total capitalization ratio (%) (3) (4) Adjusted debt-to-adjusted EBITDA (times) (3) (4) Operations (5) Statistical operating data Gross ton miles (GTMs) (millions) Revenue ton miles (RTMs) (millions) Carloads (thousands) Route miles (includes Canada and the U.S.) Employees (end of year) Employees (average for the year) Key operating measures Rail freight revenue per RTM (cents) Rail freight revenue per carload ($) GTMs per average number of employees (thousands) Operating expenses per GTM (cents) Labor and fringe benefits expense per GTM (cents) Diesel fuel consumed (US gallons in millions) Average fuel price ($/US gallon) GTMs per US gallon of fuel consumed Terminal dwell (hours) Train velocity (miles per hour) Safety indicators (6) Injury frequency rate (per 200,000 person hours) Accident rate (per million train miles) 2015 2014 2013 12,611 11,905 5,266 3,538 4.39 4.44 2,373 2,706 1,750 1.25 36,402 21,452 14,950 58.2 42.5 1.71 12,134 11,455 4,624 3,167 3.85 3.76 2,220 2,297 1,505 1.00 31,687 18,217 13,470 61.9 40.0 1.57 10,575 9,951 3,873 2,612 3.09 3.06 1,623 2,017 1,400 0.86 29,988 17,035 12,953 63.4 39.3 1.72 442,084 224,710 5,485 19,600 23,172 24,575 448,765 232,138 5,625 19,600 25,530 24,635 401,390 210,133 5,190 20,000 23,721 23,705 5.30 2,170 17,989 1.66 0.54 425.0 2.68 1,040 15.0 26.3 4.93 2,036 18,217 1.67 0.52 440.5 3.72 1,019 16.9 25.7 4.74 1,917 16,933 1.67 0.54 403.7 3.55 994 15.8 26.6 1.63 2.06 1.81 2.73 1.69 2.11 (1) See the section entitled Adjusted performance measures in the MD&A for an explanation of this non-GAAP measure. (2) See the section entitled Liquidity and capital resources - Free cash flow in the MD&A for an explanation of this non-GAAP measure. (3) As a result of the retrospective adoption of new accounting standards in the fourth quarter of 2015, certain 2014 and 2013 balances have been adjusted and the related financial ratios have been restated. See Note 2 - Recent accounting pronouncements to the Company’s 2015 Annual Consolidated Financial Statements for additional information. (4) See the section entitled Liquidity and capital resources - Credit measures in the MD&A for an explanation of this non-GAAP measure. (5) Statistical operating data, key operating measures and safety indicators are unaudited and based on estimated data available at such time and are subject to change as more complete information becomes available, as such, certain of the comparative data have been restated. Definitions of these indicators are provided on our website, www.cn.ca/glossary. (6) Based on Federal Railroad Administration (FRA) reporting criteria. 10 CN | 2015 Annual Report Management’s Discussion and Analysis This Management’s Discussion and Analysis (MD&A) dated February 1, 2016, relates to the consolidated financial position and results of operations of Canadian National Railway Company, together with its wholly-owned subsidiaries, collectively “CN” or the “Company,” and should be read in conjunc- tion with the Company’s 2015 Annual Consolidated Financial Statements and Notes thereto. All financial information reflected herein is expressed in Canadian dollars, and prepared in accordance with United States generally accepted accounting principles (U.S. GAAP), unless otherwise noted. CN’s common shares are listed on the Toronto and New York stock exchanges. Additional information about CN filed with Canadian securities regulatory authorities and the United States Securities and Exchange Commission (SEC), including the Company’s 2015 Annual Information Form and Form 40-F, may be found online at www.sedar.com, www.sec.gov, and on our website, www.cn.ca/regulatory-filings. The Company’s Notice of Intention to Make a Normal Course Issuer Bid may be found online at www.sedar.com and www.sec.gov. Copies of such documents may be obtained by contacting the Corporate Secretary’s office. Business profile information on the Company’s corporate organization, as well as selected financial information by geographic area. CN is engaged in the rail and related transportation business. CN’s network of approximately 20,000 route miles of track spans Canada and mid-America, uniquely connecting three coasts: the Atlantic, the Strategy overview Pacific and the Gulf of Mexico. CN’s extensive network and efficient connections to all Class I railroads provide CN customers access to all three North American Free Trade Agreement (NAFTA) nations. A CN’s business strategy is anchored on the continuous pursuit of Operational and Service Excellence, an unwavering commitment true backbone of the economy, CN handles over $250 billion worth to safety and sustainability, and the development of a solid team of goods annually and carries more than 300 million tons of cargo, of motivated and competent railroaders. CN’s goal is to deliver serving exporters, importers, retailers, farmers and manufacturers. valuable transportation services for its customers and to grow the CN’s freight revenues are derived from seven commodity groups business at low incremental cost. CN thereby creates value for representing a diversified and balanced portfolio of goods transported its shareholders by striving for sustainable financial performance between a wide range of origins and destinations. This product and through profitable top-line growth, adequate free cash flow and geographic diversity better positions the Company to face economic return on invested capital. CN is also focused on returning value fluctuations and enhances its potential for growth opportunities. In to shareholders through dividend payments and share repurchase 2015, no individual commodity group accounted for more than 23% programs. With a clear strategic agenda, driven by a commitment of total revenues. From a geographic standpoint, 18% of revenues to innovation, productivity, supply-chain collaboration, while relate to United States (U.S.) domestic traffic, 33% transborder running trains safely and minimizing environmental impact, CN aims traffic, 18% Canadian domestic traffic and 31% overseas traffic. The to create value for its customers as well as its shareholders. Company is the originating carrier for approximately 85% of traffic CN’s success is dependent on long-term economic viability and moving along its network, which allows it both to capitalize on service on the presence of a supportive regulatory and policy environment advantages and build on opportunities to efficiently use assets. that drives investment and innovation. CN’s success also depends Corporate organization on a stream of capital investments that supports its business strategy. These investments cover a wide range of areas, from track infrastructure and rolling stock, to information technology and other equipment and assets that improve the safety, efficiency and The Company manages its rail operations in Canada and the U.S. as reliability of CN’s service offering. Investments in track infrastructure one business segment. Financial information reported at this level, enhance the productivity and integrity of the plant, and increase such as revenues, operating income and cash flow from operations, the capacity and the fluidity of the network. The acquisition of new is used by the Company’s corporate management in evaluating locomotives and cars generates several key benefits. New motive financial and operational performance and allocating resources power increases fuel productivity and efficiency, and improves the across CN’s network. The Company’s strategic initiatives are de- reliability of service. Units equipped with distributed power allow veloped and managed centrally by corporate management and are for greater productivity of trains, particularly in cold weather, while communicated to its regional activity centers (the Western Region, improving train handling and safety. Targeted car acquisitions Eastern Region and Southern Region), whose role is to manage aim to tap growth opportunities, complementing the fleet of the day-to-day service requirements of their respective territories, privately owned railcars that traverse CN’s network. CN’s strategic control direct costs incurred locally, and execute the strategy and investments in information technology provide access to timely and operating plan established by corporate management. accurate information which supports CN’s ongoing efforts to drive See Note 18 – Segmented information to the Company’s innovation and efficiency in service, cost control, asset utilization, 2015 Annual Consolidated Financial Statements for additional safety and employee engagement. CN | 2015 Annual Report 11 Balancing “Operational and Service Excellence” CN’s broad-based service innovations benefit customers and The basic driver of the Company’s business is demand for reliable, support the Company’s goal to drive top-line growth. CN under- efficient, and cost effective transportation for customers. As such, stands the importance of being the best operator in the business, the Company’s focus is the pursuit of Operational and Service and being the best service innovator as well. Excellence: striving to operate safely and efficiently while providing a high level of service to customers. Delivering safely and responsibly For many years, CN has operated with a mindset that drives CN is committed to the safety of its employees, the communities in cost efficiency and asset utilization. That mindset flows naturally which it operates and the environment. Safety consciousness per- from CN’s Precision Railroading model, which focuses on improving meates every aspect of CN’s operations. The Company’s long-term every process that affects delivery of customers’ goods. It is a highly safety improvement is driven by continued significant investments disciplined process whereby CN handles individual rail shipments in infrastructure, rigorous safety processes and a focus on employee according to a specific trip plan and manages all aspects of railroad training and safety awareness. CN continues to strengthen its safety operations to meet customer commitments efficiently and profitably. culture by investing significantly in training, coaching, recognition This calls for the relentless measurement of results and the use of and employee involvement initiatives. such results to generate further execution improvements in the CN’s Safety Management Plan is the framework for putting service provided to customers. The Company’s continuous search safety at the center of its day-to-day operations. This proactive plan for efficiency is best captured in its performance according to key is designed to minimize risk, drive continuous improvement in the operating metrics such as car velocity, train speed and locomotive reduction of injuries and accidents, and engage employees at all productivity. All are at the center of a highly productive and fluid levels of the organization. CN believes that the rail industry can railroad operation, requiring daily engagement in the field. The enhance safety by working more closely with communities. Under Company works hard to run more efficient trains, reduce dwell times CN’s structured Community Engagement program, the Company at terminals and improve overall network velocity. With CN’s business engages with municipal officers and their emergency responders model, fewer railcars and locomotives are needed to ship the same in an effort to assist them in their emergency response planning. In amount of freight in a tight, reliable and efficient operation. The rail- many cases, this outreach includes face-to-face meetings, during road is run based on a disciplined operating methodology, executing which CN discusses its comprehensive safety programs; its safety with a sense of urgency and accountability. This philosophy is a key performance; the nature, volume and economic importance of contributor to CN’s earnings growth and return on invested capital. dangerous commodities it transports through their communities; a CN understands the importance of balancing its drive for pro- review of emergency response planning; and arranging for training ductivity with efforts to enhance customer service. The Company’s sessions for emergency responders. The outreach builds on CN’s efforts to deliver Operational and Service Excellence are anchored on an end-to-end supply chain mindset, working closely with involvement in the Transportation Community Awareness and Emergency Response (TRANSCAER®), through which the Company customers and supply chain partners, as well as involving all relevant has been working for many years to help communities in Canada areas of the Company in the process. By fostering better end-to- and the U.S. understand the movement of hazardous materials and end service performance, encouraging all supply-chain players to what is required in the event of transportation incidents. move away from a silo mentality to daily engagement, information CN has been deepening its commitment to a sustainable sharing, problem solving, and execution, CN aims to help customers operation for many years, and has made sustainability an integral achieve greater competitiveness in their own markets. Supply Chain part of its business strategy. The best way in which CN can positively Collaboration Agreements with ports, terminal operators and impact the environment is by continuously improving the efficiency customers leverage key performance metrics that drive efficiencies of its operations, and reducing its carbon footprint. As part of the across the entire supply chain. Company’s comprehensive sustainability action plan and to comply The Company is strengthening its commitment to Operational with the CN Environmental Policy, the Company engages in a and Service Excellence through a wide range of innovations number of initiatives, including the use of fuel-efficient locomotives anchored on its continuous improvement philosophy. CN is building and trucks that reduce greenhouse gas emissions; increasing oper- on its industry leadership in terms of fast and reliable hub-to-hub ational and building efficiencies; investing in energy-efficient data service by continuing to improve across the range of customer centers and recycling programs for information technology systems; touch points. The Company’s major push in first-mile/last-mile reducing, recycling and reusing waste and scrap at its facilities and service is all about improving the quality of customer interactions – on its network; engaging in modal shift agreements that favor developing a sharper outside-in perspective; better monitoring of low emission transport services; and participating in the Carbon traffic forecasts; higher and more responsive car order fulfillment; Disclosure Project to gain a more comprehensive view of its carbon and proactive customer communication at the local level, supported footprint. The Company combines its expert resources, environmental by iAdvise, an information tool that is improving the reliability and management procedures, training and audits for employees and consistency of shipment information. contractors, and emergency preparedness response activities to help 12 CN | 2015 Annual Report Management’s Discussion and Analysis ensure that it conducts its operations and activities while protecting • The Company repurchased 23.3 million common shares during the natural environment. The Company’s environmental activities the year, returning $1.75 billion to its shareholders. include monitoring CN’s environmental performance in Canada • CN spent $2.7 billion in its capital program, with $1.53 billion and the U.S. (ensuring compliance), identifying environmental targeted at maintaining the safety and integrity of the network, issues inside the Company, and managing them in accordance with particularly track infrastructure; $555 million for equipment CN’s Environmental Policy. The Environmental Policy is overseen by capital expenditures, including 90 new high-horsepower the Environment, Safety and Security Committee of the Board of locomotives, and $615 million on initiatives to support growth Directors, and all employees must demonstrate commitment to it at and drive productivity. all times. Certain risk mitigation strategies, such as periodic audits, • The Company’s sustainability practices once again earned employee training programs and emergency plans and procedures, it a place on the Dow Jones Sustainability World and North are in place to minimize the environmental risks to the Company. American Indexes. The CN Environmental Policy, the Company’s CDP (“Carbon Disclosure Project”) Report, the Corporate Citizenship Report Growth opportunities and assumptions “Delivering Responsibly” and the Company’s Corporate In 2016, the Company sees growth opportunities related to Governance Manual, which outlines the role and responsibility of intermodal traffic, as well as commodities tied to U.S. housing the Environment, Safety and Security Committee of the Board of construction and automotive sales. Overall, the Company expects Directors, are available on CN’s website. North American industrial production to increase by approximately one percent. For the 2015/2016 crop year, the Canadian grain Building a solid team of railroaders crop was in line with the five-year average and the U.S. grain crop CN’s ability to develop the best railroaders in the industry has been a was above the five-year average. The Company assumes that the key contributor to the Company’s success. CN recognizes that with- 2016/2017 grain crops in both Canada and the U.S. will be in line out the right people – no matter how good a service plan or business with their respective five-year averages. model a company may have – it will not be able to fully execute. The Company is addressing changes in employee demographics that will Value creation in 2016 span multiple years, with the workforce undergoing a major renewal. • CN plans to invest approximately $2.9 billion in its 2016 This is why the Company is focused on hiring the right people, capital program, of which $1.5 billion is targeted toward track onboarding them successfully, helping them build positive relation- infrastructure, $0.6 billion on equipment capital expenditures, ships with their colleagues, and helping all employees to grow and including adding 90 new high-horsepower locomotives, develop. As part of its strategy to build a solid team of railroaders, the $0.4 billion on initiatives to drive productivity, and $0.4 billion Company leverages its state-of-the-art training facilities in preparing associated with the U.S. federal government legislative Positive employees to be highly skilled, safety conscious and confident in their Train Control (PTC) implementation. work environment. Curricula for technical training and leadership • The Company’s Board of Directors approved an increase of development has been designed to meet the learning needs of CN’s 20% to the quarterly dividend to common shareholders, from railroaders – both current and future. These programs and initiatives $0.3125 per share in 2015 to $0.3750 per share in 2016. provide a solid platform for the assessment and development of the • The Company’s share repurchase program allows for the repurchase Company’s talent pool, and are tightly integrated with the Company’s of up to 33.0 million common shares between October 30, 2015 business strategy. Progress made in developing current and future and October 29, 2016. As at December 31, 2015, the Company leaders through the Company’s leadership development programs is has repurchased 5.8 million common shares under this program. reviewed by the Human Resources and Compensation Committee of the Board of Directors. 2015 Highlights The forward-looking statements discussed in this MD&A are subject to risks and uncertainties that could cause actual results or performance to differ materially from those expressed or • The Company attained record revenues, operating income, net implied in such statements and are based on certain factors and income, and earnings per share. assumptions which the Company considers reasonable, about • The Company attained a record operating ratio of 58.2%. events, developments, prospects and opportunities that may not • The Company attained record free cash flow of $2,373 million. materialize or that may be offset entirely or partially by other See the section of this MD&A entitled Liquidity and capital events and developments. For assumptions and risk factors, see resources – Free cash flow for an explanation of this non-GAAP the sections of this MD&A entitled Forward-looking statements, measure. Strategy overview – Growth opportunities and assumptions, and • The Company paid quarterly dividends of $0.3125 per share, Business risks. representing an increase of 25% when compared to 2014, amounting to $996 million. CN | 2015 Annual Report 13 Management’s Discussion and Analysis Forward-looking statements Certain information included in this MD&A are “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. These forward-looking statements include, but are not limited to, statements with respect to growth opportunities; statements that the Company will benefit from growth in North American and global economies; the anticipation that cash flow from operations and from various sources of financing will be sufficient to meet debt repayments and future obligations in the foreseeable future; statements regarding future payments, including income taxes and pension contributions; as well as the projected capital spending program. Forward-looking statements could further be identified by the use of terminology such as the Company “believes,” “expects,” “anticipates,” “assumes” or other similar words. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the outlook or any future results or performance implied by such statements. Key assumptions used in determining forward-looking information are set forth below. See also the section of this MD&A entitled Strategy overview - Growth opportunities and assumptions. Forward-looking statements Key assumptions or expectations Statements relating to general economic and • North American and global economic growth business conditions, including those referring • Long-term growth opportunities being less affected by current economic conditions to revenue growth opportunities Statements relating to the Company’s ability to • North American and global economic growth meet debt repayments and future obligations • Adequate credit ratios in the foreseeable future, including income tax • Investment-grade credit ratings payments, and capital spending • Access to capital markets Statements relating to pension contributions • Adequate cash generated from operations and other sources of financing • Adequate cash generated from operations and other sources of financing • Adequate long-term return on investment on pension plan assets • Level of funding as determined by actuarial valuations, particularly influenced by discount rates for funding purposes Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions; industry competition; inflation, currency and interest rate fluctuations; changes in fuel prices; legislative and/or regulatory developments; compliance with environmental laws and regulations; actions by regulators; various events which could disrupt operations, including natural events such as severe weather, droughts, floods and earthquakes; labor negotiations and disruptions; environmental claims; uncertainties of investigations, proceedings or other types of claims and litigation; risks and liabilities arising from derailments; and other risks detailed from time to time in reports filed by CN with securities regulators in Canada and the U.S. See the section entitled Business risks of this MD&A for detailed information on major risk factors. CN assumes no obligation to update or revise forward-looking statements to reflect future events, changes in circumstances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that statement, related matters, or any other forward-looking statement. Financial outlook During the year, the Company issued and updated its 2015 financial outlook. The 2015 actual results were in line with the Company’s last 2015 financial outlook that was issued on October 27, 2015. 14 CN | 2015 Annual Report Management’s Discussion and Analysis Financial highlights In millions, except percentage and per share data 2015 2014 2013 2015 vs 2014 2014 vs 2013 Change Favorable/(Unfavorable) Revenues Operating income Net income Adjusted net income (1) Basic earnings per share Adjusted basic earnings per share (1) Diluted earnings per share Adjusted diluted earnings per share (1) Dividends declared per share Total assets (2) Total long-term liabilities (2) Operating ratio Free cash flow (3) $ 12,611 $ 12,134 $ 10,575 $ 5,266 $ 4,624 $ 3,873 $ 3,538 $ 3,167 $ 2,612 $ 3,580 $ 3,095 $ 2,582 $ 4.42 $ 3.86 $ 3.10 $ 4.47 $ 3.77 $ 3.07 $ 4.39 $ 3.85 $ 3.09 $ 4.44 $ 3.76 $ 3.06 $ 1.25 $ 1.00 $ 0.86 $ 36,402 $ 31,687 $ 29,988 $ 18,454 $ 16,016 $ 14,537 58.2% 61.9% 63.4% $ 2,373 $ 2,220 $ 1,623 4% 14% 12% 16% 15% 19% 14% 18% 25% 15% (15%) 3.7-pts 7% 15% 19% 21% 20% 25% 23% 25% 23% 16% 6% (10%) 1.5-pts 37% (1) See the section of this MD&A entitled Adjusted performance measures for an explanation of this non-GAAP measure. (2) As a result of the retrospective adoption of new accounting standards in the fourth quarter of 2015, certain 2014 and 2013 balances have been adjusted. See the section of this MD&A entitled Recent accounting pronouncements for additional information. (3) See the section of this MD&A entitled Liquidity and capital resources - Free cash flow for an explanation of this non-GAAP measure. 2015 compared to 2014 In 2015, net income was $3,538 million, an increase of $371 million, or 12%, when compared to 2014, with diluted earnings per share rising 14% to $4.39. The $371 million increase was mainly due to higher operating income net of the related income taxes, partly offset by an increase in Interest expense and a decrease in Other income. Operating income for the year ended December 31, 2015 increased by $642 million, or 14%, to $5,266 million. The operating ratio, defined as operating expenses as a percentage of revenues, was 58.2% in 2015, compared to 61.9% in 2014, a 3.7-point improvement. Revenues for the year ended December 31, 2015 increased by $477 million, or 4%, to $12,611 million, mainly attributable to: • • the positive translation impact of the weaker Canadian dollar on US dollar-denominated revenues; freight rate increases; and • solid overseas intermodal demand, higher volumes of finished vehicle traffic, and increased shipments of lumber and panels to U.S. markets. These factors were partly offset by a lower applicable fuel surcharge rate; and decreased shipments of energy-related commodities including crude oil, frac sand and drilling pipe, lower volumes of semi-finished steel products and short-haul iron ore, reduced shipments of coal due to weaker North American and global demand, as well as lower U.S. grain exports via the Gulf of Mexico. Operating expenses for the year ended December 31, 2015 decreased by $165 million, or 2%, to $7,345 million, primarily due to lower fuel expense and cost-management efforts, partly offset by the negative translation impact of a weaker Canadian dollar on US dollar- denominated expenses. CN | 2015 Annual Report 15 Management’s Discussion and Analysis Adjusted performance measures Management believes that adjusted net income and adjusted The following table provides a reconciliation of net income and earnings per share, as reported for the years ended December 31, 2015, 2014 and 2013, to the adjusted performance measures earnings per share are useful measures of performance that can presented herein: facilitate period-to-period comparisons, as they exclude items that do not necessarily arise as part of the normal day-to-day operations of the Company and could distort the analysis of trends in business performance. The exclusion of such items in adjusted net income and adjusted earnings per share does not, however, imply that such items are necessarily non-recurring. These adjusted measures do not have any standardized meaning prescribed by GAAP and therefore, may not be comparable to similar measures presented by other In millions, except per share data Year ended December 31, 2015 2014 2013 Net income as reported $ 3,538 $ 3,167 $ 2,612 Adjustments: Other income Income tax expense Adjusted net income - 42 (80) 8 (69) 39 $ 3,580 $ 3,095 $ 2,582 companies. Basic earnings per share as reported $ 4.42 $ 3.86 $ 3.10 For the year ended December 31, 2015, the Company reported Impact of adjustments, per share 0.05 (0.09) (0.03) adjusted net income of $3,580 million, or $4.44 per diluted share. Adjusted basic earnings per share $ 4.47 $ 3.77 $ 3.07 The adjusted figures for the year ended December 31, 2015 exclude a deferred income tax expense of $42 million ($0.05 per diluted share) resulting from the enactment of a higher provincial corporate Diluted earnings per share as reported $ 4.39 $ 3.85 $ 3.09 Impact of adjustments, per share 0.05 (0.09) (0.03) Adjusted diluted earnings per share $ 4.44 $ 3.76 $ 3.06 income tax rate. For the year ended December 31, 2014, the Company reported adjusted net income of $3,095 million, or $3.76 per diluted share. The adjusted figures for the year ended December 31, 2014 exclude a gain on disposal of the Deux-Montagnes subdivision, including the Mont-Royal tunnel, together with the rail fixtures (collectively the “Deux-Montagnes”), of $80 million, or $72 million after-tax ($0.09 per diluted share). For the year ended December 31, 2013, the Company reported adjusted net income of $2,582 million, or $3.06 per diluted share. The adjusted figures for the year ended December 31, 2013 exclude a gain on exchange of perpetual railroad operating easements including the track and roadway assets on specific rail lines (collect- ively the “exchange of easements”) of $29 million, or $18 million after-tax ($0.02 per diluted share) and a gain on disposal of a segment of the Oakville subdivision, together with the rail fixtures and certain passenger agreements (collectively the “Lakeshore West”) of $40 million, or $36 million after-tax ($0.04 per diluted share). The adjusted figures also exclude a $24 million ($0.03 per diluted share) income tax expense from the enactment of higher provincial corporate income tax rates. Constant currency Financial results at constant currency allow results to be viewed without the impact of fluctuations in foreign currency exchange rates, thereby facilitating period-to-period comparisons in the analysis of trends in business performance. Measures at constant currency are considered non-GAAP measures and do not have any standardized meaning prescribed by GAAP and therefore, may not be comparable to similar measures presented by other companies. Financial results at constant currency are obtained by translating the current period results denominated in US dollars at the foreign exchange rates of the comparable period of the prior year. The average foreign exchange rates were $1.28 and $1.10 per US$1.00, for the years ended December 31, 2015 and 2014, respectively. On a constant currency basis, the Company’s net income for the year ended December 31, 2015 would have been lower by $314 million ($0.39 per diluted share). 16 CN | 2015 Annual Report Management’s Discussion and Analysis Revenues In millions, unless otherwise indicated Year ended December 31, 2015 % Change at constant currency 2014 % Change Rail freight revenues $ 11,905 $ 11,455 Other revenues Total revenues Rail freight revenues 706 679 $ 12,611 $ 12,134 4% 4% 4% (4%) (6%) (5%) Petroleum and chemicals $ 2,442 $ 2,354 4% (6%) Metals and minerals Forest products Coal Grain and fertilizers Intermodal Automotive 1,437 1,728 612 2,071 2,896 719 1,986 2,748 620 Total rail freight revenues $ 11,905 $ 11,455 Revenue ton miles (RTMs) (millions) 224,710 232,138 Rail freight revenue/RTM (cents) 5.30 4.93 Carloads (thousands) 5,485 5,625 Rail freight revenue/carload 1,484 1,523 (3%) (13%) 13% 2% 740 (17%) (25%) 4% 5% 16% 4% (3%) 8% (2%) (3%) - 4% (4%) (3%) (1%) (2%) (dollars) 2,170 2,036 7% (2%) Revenues for the year ended December 31, 2015, totaled Petroleum and chemicals Year ended December 31, 2015 % Change at constant currency 2014 % Change Revenues (millions) $ 2,442 $ 2,354 RTMs (millions) 51,103 53,169 Revenue/RTM (cents) 4.78 4.43 4% (4%) 8% (6%) (4%) (2%) The petroleum and chemicals commodity group comprises a wide range of commodities, including chemicals and plastics, refined petroleum products, natural gas liquids, crude oil and sulfur. The primary markets for these commodities are within North America, and as such, the performance of this commodity group is closely correlated with the North American economy as well as oil and $12,611 million compared to $12,134 million in 2014. The increase gas production. Most of the Company’s petroleum and chemicals of $477 million, or 4%, was mainly attributable to the positive shipments originate in the Louisiana petrochemical corridor translation impact of the weaker Canadian dollar on US dollar- between New Orleans and Baton Rouge; in Western Canada, a denominated revenues; freight rate increases; and solid overseas key oil and gas development area and a major center for natural intermodal demand, higher volumes of finished vehicle traffic, and gas feedstock and world-scale petrochemicals and plastics; and in increased shipments of lumber and panels to U.S. markets. These eastern Canadian regional plants. factors were partly offset by a lower applicable fuel surcharge rate; For the year ended December 31, 2015, revenues for this and decreased shipments of energy-related commodities including commodity group increased by $88 million, or 4%, when compared crude oil, frac sand and drilling pipe, lower volumes of semi-finished to 2014. The increase was mainly due to the positive translation steel products and short-haul iron ore, reduced shipments of coal impact of a weaker Canadian dollar, freight rate increases and due to weaker North American and global demand, as well as lower higher shipments of natural gas liquids. These factors were partly U.S. grain exports via the Gulf of Mexico. offset by decreased shipments of crude oil and a lower applicable Fuel surcharge revenues decreased by $575 million in 2015, fuel surcharge rate. mainly due to lower applicable fuel surcharge rates and lower Revenue per RTM increased by 8% in 2015, mainly due to the freight volumes, partly offset by the positive translation impact of positive translation impact of a weaker Canadian dollar and freight the weaker Canadian dollar. rate increases, partly offset by a lower applicable fuel surcharge rate. In 2015, revenue ton miles (RTMs), measuring the relative weight and distance of rail freight transported by the Company, Percentage of 2015 revenues Carloads (thousands) declined by 3% relative to 2014. 40% Chemicals and plastics Year ended December 31, Rail freight revenue per RTM, a measurement of yield defined as revenue earned on the movement of a ton of freight over one mile, 29% Refined petroleum products 25% Crude and condensate increased by 8% when compared to 2014, driven by the positive 6% Sulfur translation impact of the weaker Canadian dollar and freight rate increases, partly offset by a significant increase in the average length of haul, particularly in the second half of the year, and a lower applicable fuel surcharge rate. 40% 29% 25% 6% 2013 611 2014 655 2015 640 CN | 2015 Annual Report 17 Management’s Discussion and Analysis Management’s Discussion and Analysis Forest products Year ended December 31, 2015 % Change at constant currency 2014 % Change Revenues (millions) $ 1,728 $ 1,523 RTMs (millions) 30,097 29,070 Revenue/RTM (cents) 5.74 5.24 13% 4% 10% 2% 4% (2%) Metals and minerals Year ended December 31, 2015 % Change at constant currency 2014 % Change Revenues (millions) $ 1,437 $ 1,484 (3%) RTMs (millions) 21,828 24,686 (12%) Revenue/RTM (cents) 6.58 6.01 9% (13%) (12%) (2%) The forest products commodity group includes various types of lumber, panels, paper, wood pulp and other fibers such as logs, recycled paper, wood chips, and wood pellets. The Company has extensive rail access to the western and eastern Canadian fiber-producing regions, which The metals and minerals commodity group consists primarily are among the largest fiber source of materials related to oil and gas development, steel, iron ore, areas in North America. In the non-ferrous base metals and ores, construction materials and U.S., the Company is strategically machinery and dimensional (large) loads. The Company provides located to serve both the Midwest unique rail access to base metals, iron ore and frac sand mining as and southern U.S. corridors with well as aluminum and steel producing regions, which are among the most important in North America. This strong origin franchise, coupled with the Company’s access to port facilities and the end markets for these commodities, has made CN a leader in the transportation of metals and minerals products. The key drivers interline connections to other Class I railroads. The key drivers for the various commodities are: for lumber and panels, housing starts and renovation activities primarily for this market segment are oil and gas development, automotive in the U.S.; for fibers (mainly wood production, and non-residential construction. pulp), the consumption of paper, For the year ended December 31, 2015, revenues for this com- pulpboard and tissue in North American and offshore markets; modity group decreased by $47 million, or 3%, when compared and for newsprint, advertising lineage, non-print media and overall to 2014. The decrease was mainly due to decreased shipments of economic conditions, primarily in the U.S. energy-related commodities including frac sand and drilling pipe For the year ended December 31, 2015, revenues for this com- due to a reduction in oil and gas activities, and lower volumes of modity group increased by $205 million, or 13%, when compared semi-finished steel products and short-haul iron ore; as well as a to 2014. The increase was mainly due to the positive translation im- lower applicable fuel surcharge rate. These factors were partly offset pact of a weaker Canadian dollar; freight rate increases; and higher by the positive translation impact of a weaker Canadian dollar and shipments of lumber and panels to U.S. markets, and increased freight rate increases. offshore shipments of wood pulp. These factors were partly offset Revenue per RTM increased by 9% in 2015, mainly due to the by a lower applicable fuel surcharge rate and decreased shipments positive translation impact of a weaker Canadian dollar and freight of paper products. rate increases, partly offset by a significant increase in the average Revenue per RTM increased by 10% in 2015, mainly due to the length of haul and a lower applicable fuel surcharge rate. positive translation impact of a weaker Canadian dollar and freight Percentage of 2015 revenues Carloads (thousands) 29% Metals Year ended December 31, Percentage of 2015 revenues Carloads (thousands) rate increases, partly offset by a lower applicable fuel surcharge rate. 2013 1,048 2014 1,063 2015 886 50% Pulp and paper Year ended December 31, 50% Lumber and panels 50% 50% 2013 446 2014 433 2015 441 28% Energy materials 27% Minerals 16% Iron ore 29% 28% 16% 27% 18 CN | 2015 Annual Report Management’s Discussion and Analysis Coal Year ended December 31, 2015 % Change at constant currency 2014 % Change Grain and fertilizers Revenues (millions) $ 612 $ 740 RTMs (millions) 15,956 21,147 (17%) (25%) Revenue/RTM (cents) 3.84 3.50 10% (25%) (25%) (1%) The coal commodity group consists of thermal grades of bituminous coal, metallurgical coal and petroleum coke. Canadian thermal and Year ended December 31, 2015 % Change at constant currency 2014 % Change Revenues (millions) $ 2,071 $ 1,986 RTMs (millions) 50,001 51,326 Revenue/RTM (cents) 4.14 3.87 4% (3%) 7% (3%) (3%) - metallurgical coal are largely exported via terminals on the west The grain and fertilizers commodity group depends primarily on crops coast of Canada to offshore markets. In the U.S., thermal coal is grown and fertilizers processed in Western Canada and the U.S. transported from mines served in southern Illinois, or from western Midwest. The grain segment consists of three primary segments: food U.S. mines via interchange with other railroads, to major utilities grains (mainly wheat, oats and malting barley), feed grains and feed in the Midwest and Southeast U.S., as well as offshore markets via grain products (including feed barley, feed wheat, peas, corn, ethanol terminals in the Gulf of Mexico. and dried distillers grains), and oilseeds and oilseed products (primarily For the year ended December 31, 2015, revenues for this com- canola seed, oil and meal, and soybeans). Production of grain varies modity group decreased by $128 million, or 17%, when compared to considerably from year to year, affected primarily by weather conditions, 2014. The decrease was mainly due to lower shipments of metal- seeded and harvested acreage, the mix of grains produced and crop lurgical and thermal coal through west coast ports, and decreased yields. Grain exports are sensitive to the size and quality of the crop pro- volumes of thermal coal to U.S. utilities, and a lower applicable fuel duced, international market conditions and foreign government policy. surcharge rate. These factors were partly offset by the positive trans- The majority of grain produced in Western Canada and moved by CN lation impact of a weaker Canadian dollar and freight rate increases. is exported via the ports of Vancouver, Prince Rupert and Thunder Bay. Revenue per RTM increased by 10% in 2015, mainly due to Certain of these rail movements are subject to government regulation a significant decrease in the average length of haul, the positive and to a revenue cap, which effectively establishes a maximum revenue translation impact of a weaker Canadian dollar, and freight rate entitlement that railways can earn. In the U.S., grain grown in Illinois increases, partly offset by a lower applicable fuel surcharge rate. and Iowa is exported as well as transported to domestic processing Percentage of 2015 revenues Carloads (thousands) facilities and feed markets. The Company also serves major producers of potash in Canada, as well as producers of ammonium nitrate, urea and 85% Coal 15% Petroleum coke 15% 85% Year ended December 31, other fertilizers across Canada and the U.S. 2013 416 2014 519 2015 438 For the year ended December 31, 2015, revenues for this commodity group increased by $85 million, or 4%, when compared to 2014. The increase was mainly due to the positive translation impact of a weaker Canadian dollar and freight rate increases, as well as higher shipments of potash and lentils. These factors were partly offset by lower U.S. corn and soybeans exports via the Gulf of Mexico, lower volumes of corn to domestic processing facilities, and reduced export shipments of Canadian wheat and barley; as well as a lower applicable fuel surcharge rate. Revenue per RTM increased by 7% in 2015, mainly due to the positive translation impact of a weaker Canadian dollar and freight rate increases, partly offset by a lower applicable fuel surcharge rate and an increase in the average length of haul. Percentage of 2015 revenues Carloads (thousands) 31% Oilseeds 27% Food grains 22% Feed grains 20% Fertilizers 31% 27% 20% 22% Year ended December 31, 2013 572 2014 640 2015 607 CN | 2015 Annual Report 19 Management’s Discussion and Analysis Management’s Discussion and Analysis Automotive Year ended December 31, 2015 % Change at constant currency 2014 % Change Revenues (millions) $ 719 $ 620 RTMs (millions) Revenue/RTM (cents) 3,581 20.08 3,159 19.63 16% 13% 2% 4% 13% (9%) The automotive commodity group moves both domestic finished vehicles and parts throughout North America, providing rail access to certain vehicle assembly plants in Canada, and Michigan and Mississippi in the Intermodal Year ended December 31, 2015 % Change at constant currency 2014 % Change Revenues (millions) $ 2,896 $ 2,748 RTMs (millions) 52,144 49,581 Revenue/RTM (cents) 5.55 5.54 5% 5% - - 5% (5%) The intermodal commodity group includes rail and trucking services U.S. The Company also serves vehicle distribu- and is comprised of two segments: domestic and international. The tion facilities in Canada and the U.S., as well domestic segment transports consumer products and manufactured as parts production facilities in Michigan and goods, serving both retail and wholesale channels, within domestic Ontario. The Company serves shippers of im- Canada, domestic U.S., Mexico and transborder, while the inter- port finished vehicles via the ports of Halifax national segment handles import and export container traffic, serving and Vancouver, and through interchange with the major ports of Vancouver, Prince Rupert, Montreal, Halifax, New other railroads. The Company’s automotive Orleans and Mobile. The domestic segment is driven by consumer revenues are closely correlated to automotive markets, with growth generally tied to the economy. The international production and sales in North America. segment is driven by North American economic and trade conditions. For the year ended December 31, 2015, revenues for this com- For the year ended December 31, 2015, revenues for this commod- modity group increased by $99 million, or 16%, when compared to ity group increased by $148 million, or 5%, when compared to 2014. 2014. The increase was mainly due to the positive translation impact The increase was primarily due to higher international shipments, mainly of a weaker Canadian dollar; and higher volumes of domestic through the Port of Prince Rupert, the positive translation impact of a finished vehicle traffic in the first half, as a result of new business, weaker Canadian dollar, and freight rate increases. These factors were and higher import volumes via the Port of Vancouver. These factors partly offset by a lower applicable fuel surcharge rate. were partly offset by a lower applicable fuel surcharge rate. Revenue per RTM remained flat in 2015, mainly due to the Revenue per RTM increased by 2% in 2015, mainly due to the positive translation impact of a weaker Canadian dollar and freight positive translation impact of a weaker Canadian dollar, partly offset rate increases, partly offset by a lower applicable fuel surcharge rate by a significant increase in the average length of haul and a lower and an increase in the average length of haul. applicable fuel surcharge rate. Percentage of 2015 revenues Carloads (thousands) Percentage of 2015 revenues Carloads (thousands) Year ended December 31, 93% Finished vehicles Year ended December 31, 2013 1,875 2014 2,086 2015 2,232 7% Auto parts 7% 93% 2013 222 2014 229 2015 241 64% International 36% Domestic 64% 36% Other revenues Year ended December 31, 2015 % Change at constant currency 2014 % Change Other revenues are largely derived from non-rail services that support CN’s rail business including vessels and docks, warehousing and distribution, automotive logistic services, freight forwarding and transportation management; as well as other revenues including Revenues (millions) $ 706 $ 679 4% (6%) commuter train revenues. Percentage of 2015 revenues 50% Vessels and docks 39% Other non-rail services 11% Other revenues 50% 39% 11% 20 CN | 2015 Annual Report For the year ended December 31, 2015, Other revenues increased by $27 million, or 4%, when compared to 2014, mainly due to the positive translation impact of a weaker Canadian dollar partly offset by lower revenues from vessels. Operating expenses Operating expenses for the year ended December 31, 2015 amounted to $7,345 million compared to $7,510 million in 2014. The decrease of $165 million, or 2%, in 2015 was mainly due to lower fuel expense and cost-management efforts, partly offset by the negative translation impact of a weaker Canadian dollar on US dollar-denominated expenses. In millions Year ended December 31, 2015 2014 % Change % Change at constant currency Percentage of revenues 2015 2014 Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses $ 2,406 $ 2,319 1,729 1,598 1,285 1,846 1,158 1,050 373 394 329 368 $ 7,345 $ 7,510 (4%) (8%) 30% (10%) (13%) (7%) 2% 2% (1%) 39% (4%) - 3% 9% 19.1% 13.7% 10.2% 9.2% 2.9% 3.1% 19.1% 13.2% 15.2% 8.7% 2.7% 3.0% 58.2% 61.9% Labor and fringe benefits Depreciation and amortization Labor and fringe benefits expense includes wages, payroll taxes, Depreciation expense is affected by capital additions, railroad and employee benefits such as incentive compensation, including property retirements from disposal, sale and/or abandonment and stock-based compensation; health and welfare; and pension and other adjustments including asset impairments. other postretirement benefits. Certain incentive and stock-based Depreciation and amortization expense increased by $108 mil- compensation plans are based on financial and market perform- lion, or 10%, in 2015 when compared to 2014. The increase was ance targets and the related expense is recorded in relation to the mainly due to net capital additions and the negative translation attainment of such targets. impact of the weaker Canadian dollar, partly offset by the favorable Labor and fringe benefits expense increased by $87 million, or impact of depreciation studies. 4%, in 2015 when compared to 2014. The increase was primarily a result of the negative translation impact of the weaker Canadian Equipment rents dollar, general wage increases and higher payroll taxes, as well as Equipment rents expense includes rental expense for the use of increased pension expense, partly offset by lower incentive-based freight cars owned by other railroads or private companies and compensation expense. for the short- or long-term lease of freight cars, locomotives and intermodal equipment, net of rental income from other railroads for Purchased services and material the use of the Company’s cars and locomotives. Purchased services and material expense primarily includes the cost Equipment rents expense increased by $44 million, or 13%, in of services purchased from outside contractors; materials used in 2015 when compared to 2014. The increase was primarily due to the maintenance of the Company’s track, facilities and equipment; the negative translation impact of the weaker Canadian dollar and transportation and lodging for train crew employees; utility costs; increased car hire expense, partly offset by higher income from the and the net costs of operating facilities jointly used by the Company use of the Company’s equipment by other railroads. and other railroads. Purchased services and material expense increased by $131 million, Casualty and other or 8%, in 2015 when compared to 2014. The increase was mainly due Casualty and other expense includes expenses for personal injuries, to the negative translation impact of the weaker Canadian dollar as environmental, freight and property damage, insurance, bad debt, well as higher cost for repairs and maintenance and for materials. operating taxes, and travel expenses. Fuel Casualty and other expense increased by $26 million, or 7%, in 2015 when compared to 2014. The increase was mainly due to the Fuel expense includes fuel consumed by assets, including loco- negative translation impact of the weaker Canadian dollar. motives, vessels, vehicles and other equipment as well as federal, provincial and state fuel taxes. Fuel expense decreased by $561 million, or 30%, in 2015 when compared to 2014. The decrease was primarily due to lower fuel prices, partly offset by the negative translation impact of the weaker Canadian dollar. CN | 2015 Annual Report 21 Management’s Discussion and Analysis Other income and expenses Interest expense Operating expenses for the year ended December 31, 2014 in- creased by $808 million, or 12%, to $7,510 million, mainly due to: • the negative translation impact of a weaker Canadian dollar on In 2015, Interest expense was $439 million compared to $371 million US dollar-denominated expenses; in 2014. The increase was mainly due to the negative translation • increased purchased services and material expense; impact of the weaker Canadian dollar on US dollar-denominated • higher fuel costs; and interest expense and a higher level of debt. • increased labor and fringe benefits expense. Other income Revenues In 2015, the Company recorded other income of $47 million com- pared to $107 million in 2014. Included in Other income for 2014 was a gain on disposal of the Deux-Montagnes of $80 million. Income tax expense The Company recorded income tax expense of $1,336 million for the year ended December 31, 2015, compared to $1,193 million in 2014. Included in the 2015 figure was a deferred income tax expense of $42 million resulting from the enactment of a higher provincial corporate income tax rate. Included in the 2014 figure was an income tax recovery of $18 million resulting from a change in estimate of the deferred income tax liability related to properties. The effective tax rate was 27.4% in 2015 and 2014. Excluding the net deferred income tax expense of $42 million in 2015 and the net income tax recovery of $18 million in 2014, the effective tax rate for 2015 was 26.5% compared to 27.8% in 2014, partially due to a higher proportion of profit in lower tax rate jurisdictions. 2014 compared to 2013 In 2014, net income was $3,167 million, an increase of $555 mil- lion, or 21%, when compared to 2013, with diluted earnings per share rising 25% to $3.85. The $555 million increase was mainly due to an increase in Operating income, net of related income taxes. Operating income for the year ended December 31, 2014 increased by $751 million, or 19%, to $4,624 million. The operating ratio, defined as operating expenses as a percentage of revenues, was 61.9% in 2014, compared to 63.4% in 2013, a 1.5-point improvement. Revenues for the year ended December 31, 2014 increased by $1,559 million or 15%, to $12,134 million, mainly attributable to: • higher freight volumes due to a record 2013/2014 Canadian grain crop, strong energy markets, particularly crude oil and frac sand, as well as new intermodal and automotive business; • the positive translation impact of the weaker Canadian dollar on US dollar-denominated revenues; and • freight rate increases. 22 CN | 2015 Annual Report In millions, unless otherwise indicated Year ended December 31, 2014 % Change at constant currency 2013 % Change Rail freight revenues $ 11,455 $ 9,951 Other revenues Total revenues Rail freight revenues 679 624 $ 12,134 $ 10,575 Petroleum and chemicals $ 2,354 $ 1,952 Metals and minerals 1,484 1,240 Forest products 1,523 1,424 Coal 740 713 Grain and fertilizers 1,986 1,638 Intermodal Automotive 2,748 2,429 620 555 Total rail freight revenues $ 11,455 $ 9,951 15% 9% 15% 21% 20% 7% 4% 21% 13% 12% 15% 11% 4% 10% 15% 14% 2% - 17% 11% 6% 11% Revenue ton miles (RTMs) (millions) 232,138 210,133 10% 10% Rail freight revenue/RTM (cents) Carloads (thousands) Rail freight revenue/carload 4.93 4.74 4% - 5,625 5,190 8% 8% (dollars) 2,036 1,917 6% 2% In order to better represent rail freight and related revenues within the commodity groups and maintain non-rail services that support CN’s rail business within Other revenues, certain other revenues were reclassified to the commodity groups within rail freight revenues. Revenues earned from trucking intermodal goods were reclassified from Other revenues to the Intermodal commodity group and services that relate to the movement of rail freight were reclassified from Other revenues to the related commodity groups. The 2013 comparative figures have been reclassified in order to be consistent with the 2014 presentation as discussed herein. This change has no impact on the Company’s previously reported results of operations as Total revenues remain unchanged. Revenues for the year ended December 31, 2014 totaled $12,134 million compared to $10,575 million in 2013. The increase of $1,559 million, or 15%, was mainly attributable to higher freight volumes due to a record 2013/2014 Canadian grain crop, strong energy markets, particularly crude oil and frac sand, new intermodal and auto- motive business; the positive translation impact of the weaker Canadian dollar on US dollar-denominated revenues; and freight rate increases. Management’s Discussion and Analysis Fuel surcharge revenues increased by $72 million in 2014, due to higher Forest products freight volumes partly offset by lower fuel surcharge rates. In 2014, revenue ton miles (RTM), measuring the relative weight and distance of rail freight transported by the Company, increased Year ended December 31, 2014 % Change at constant currency 2013 % Change by 10% relative to 2013. Rail freight revenue per revenue ton mile, a measurement of yield defined as revenue earned on the movement of a ton of freight over one mile, increased by 4% when compared to 2013, driven by the Revenues (millions) $ 1,523 $ 1,424 RTMs (millions) 29,070 29,630 Revenue/RTM (cents) 5.24 4.81 7% (2%) 9% 2% (2%) 4% positive translation impact of the weaker Canadian dollar and freight For the year ended December 31, 2014, revenues for this commodity rate increases, partly offset by an increase in the average length of haul. group increased by $99 million, or 7%, when compared to 2013. Petroleum and chemicals Year ended December 31, 2014 % Change at constant currency 2013 % Change Revenues (millions) $ 2,354 $ 1,952 RTMs (millions) 53,169 44,634 Revenue/RTM (cents) 4.43 4.37 21% 19% 1% 15% 19% (3%) The increase was mainly due to the positive translation impact of a weaker Canadian dollar, freight rate increases, and higher volumes of lumber and panels to U.S. markets. These factors were partly offset by decreased shipments of lumber and wood pulp to offshore markets and lower fuel surcharge revenues due to lower freight volumes. Revenue per revenue ton mile increased by 9% in 2014, mainly due to the positive translation impact of a weaker Canadian dollar and freight rate increases, partly offset by an increase in the average length of haul. For the year ended December 31, 2014, revenues for this commodity group increased by $402 million, or 21%, when compared to 2013. Coal The increase was mainly due to higher crude oil and natural gas liquid shipments, the positive translation impact of a weaker Canadian dollar, freight rate increases, and higher fuel surcharge revenues due to higher Year ended December 31, 2014 % Change at constant currency 2013 % Change freight volumes partly offset by a lower fuel surcharge rate. These factors were partly offset by lower volumes of chlorine and sulfur. Revenue per revenue ton mile increased by 1% in 2014, mainly due to the positive translation impact of a weaker Canadian dollar Revenues (millions) $ 740 $ 713 RTMs (millions) 21,147 22,315 Revenue/RTM (cents) 3.50 3.20 4% (5%) 9% - (5%) 5% and freight rate increases, partly offset by a significant increase in For the year ended December 31, 2014, revenues for this com- the average length of haul. Metals and minerals Year ended December 31, 2014 % Change at constant currency 2013 % Change Revenues (millions) $ 1,484 $ 1,240 RTMs (millions) 24,686 21,342 Revenue/RTM (cents) 6.01 5.81 20% 16% 3% 14% 16% (2%) modity group increased by $27 million, or 4%, when compared to 2013. The increase was mainly due to freight rate increases and the positive translation impact of a weaker Canadian dollar, partly offset by lower volumes. Decreased shipments of metallurgical coal, thermal coal, and petroleum coke through west coast ports were partly offset by increased shipments of thermal coal to U.S. utilities and for export through the Gulf. Revenue per revenue ton mile increased by 9% in 2014, mainly due to freight rate increases, the positive translation impact of a weaker Canadian dollar, and a significant decrease in the average For the year ended December 31, 2014, revenues for this commodity length of haul. group increased by $244 million, or 20%, when compared to 2013. The increase was mainly due to higher volumes of frac sand, increased shipments of semi-finished steel products, the positive translation impact of a weaker Canadian dollar, and freight rate increases. Revenue per revenue ton mile increased by 3% in 2014, mainly due to the positive translation impact of a weaker Canadian dollar and freight rate increases, partly offset by a significant increase in the average length of haul. CN | 2015 Annual Report 23 Management’s Discussion and Analysis Grain and fertilizers Year ended December 31, 2014 % Change at constant currency 2013 % Change Revenues (millions) $ 1,986 $ 1,638 RTMs (millions) 51,326 43,180 Revenue/RTM (cents) 3.87 3.79 21% 19% 2% 17% 19% (1%) For the year ended December 31, 2014, revenues for this commodity group increased by $348 million, or 21%, when compared to 2013. fuel surcharge revenues due to increased freight volumes; and freight rate increases. These increases were partly offset by reduced domestic volumes serving wholesale channels. Revenue per revenue ton mile increased by 6% in 2014, mainly due to the positive translation impact of a weaker Canadian dollar and freight rate increases. Automotive % Change at constant currency 2013 % Change The increase was mainly due to higher volumes of Canadian wheat Year ended December 31, 2014 and canola due to a record 2013/2014 Canadian grain crop, as well as increased shipments of corn and soybeans for export due to higher crop yields in the U.S.; the positive translation impact of a weaker Canadian dollar; and freight rate increases. These factors Revenues (millions) $ 620 $ 555 RTMs (millions) 3,159 2,741 12% 15% Revenue/RTM (cents) 19.63 20.25 (3%) 6% 15% (8%) were partly offset by lower volumes of fertilizers. For the year ended December 31, 2014, revenues for this commodity Revenue per revenue ton mile increased by 2% in 2014, mainly group increased by $65 million, or 12%, when compared to 2013. due to the positive translation impact of a weaker Canadian dollar The increase was mainly due to higher volumes of domestic finished and freight rate increases, partly offset by a significant increase in vehicle traffic as a result of new business and the positive trans- the average length of haul. lation impact of a weaker Canadian dollar. Intermodal Year ended December 31, 2014 % Change at constant currency 2013 % Change Revenues (millions) $ 2,748 $ 2,429 13% 11% RTMs (millions) 49,581 46,291 Revenue/RTM (cents) 5.54 5.25 7% 6% 7% 3% For the year ended December 31, 2014, revenues for this com- Revenue per revenue ton mile decreased by 3% in 2014, mainly due to a significant increase in the average length of haul, partly offset by the positive translation impact of a weaker Canadian dollar. Other revenues Year ended December 31, 2014 % Change at constant currency 2013 % Change Revenues (millions) $ 679 $ 624 9% 4% modity group increased by $319 million, or 13%, when compared For the year ended December 31, 2014, Other revenues increased to 2013. The increase was mainly due to new business and by $55 million, or 9%, when compared to 2013, mainly due to higher shipments through the ports of Vancouver and Montreal, the positive translation impact of a weaker Canadian dollar, higher and increased volumes through the Port of Prince Rupert; the revenues from vessels and docks, as well as international freight positive translation impact of a weaker Canadian dollar; higher forwarding. Operating expenses Operating expenses for the year ended December 31, 2014 amounted to $7,510 million compared to $6,702 million in 2013. The increase of $808 million, or 12%, in 2014 was mainly due to the negative translation impact of a weaker Canadian dollar on US dollar-denominated expenses, increased purchased services and material expense, higher fuel costs, as well as increased labor and fringe benefits expense. In millions Year ended December 31, 2014 2013 % Change % Change at constant currency Percentage of revenues 2014 2013 Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses 24 CN | 2015 Annual Report $ 2,319 $ 2,182 1,598 1,351 1,846 1,619 1,050 329 368 980 275 295 $ 7,510 $ 6,702 (6%) (18%) (14%) (7%) (20%) (25%) (12%) (4%) (15%) (7%) (5%) (13%) (20%) (8%) 19.1% 13.2% 15.2% 8.7% 2.7% 3.0% 20.6% 12.8% 15.3% 9.3% 2.6% 2.8% 61.9% 63.4% Management’s Discussion and Analysis Labor and fringe benefits Casualty and other Labor and fringe benefits expense increased by $137 million, or Casualty and other expense increased by $73 million, or 25%, 6%, in 2014 when compared to 2013. The increase was primarily a in 2014 when compared to 2013. The increase was mainly due result of higher headcount to accommodate volume growth, gen- to higher accident-related costs, increased property taxes and the eral wage increases, the negative translation impact of the weaker negative impact of the weaker Canadian dollar, partly offset by Canadian dollar, as well as higher stock-based compensation lower workers’ compensation expenses. expense. The increase was partly offset by a decrease in pension expense and the impact of improved labor productivity. Other income and expenses Interest expense Purchased services and material In 2014, interest expense was $371 million compared to Purchased services and material expense increased by $247 million, $357 million in 2013. The increase was mainly due to the negative or 18%, in 2014 when compared to 2013. The increase was mainly translation impact of the weaker Canadian dollar on US dollar- due to weather-related conditions in the first quarter of 2014 that denominated interest expense partly offset by lower interest impacted materials, utilities, and maintenance costs for rolling expense on capital lease obligations. stock; the negative translation impact of the weaker Canadian dollar; as well as increased freight volumes that resulted in higher Other income costs for materials and third-party non-rail transportation carriers. In 2014, the Company recorded other income of $107 million Fuel compared to $73 million in 2013. Included in Other income for 2014 was a gain on disposal of the Deux-Montagnes of $80 million. Fuel expense increased by $227 million, or 14%, in 2014 when Included in Other income for 2013 was a gain on the exchange of compared to 2013. The increase was due to higher freight volumes easements of $29 million and a gain on disposal of the Lakeshore and the negative translation impact of the weaker Canadian dollar, West of $40 million. partly offset by increased fuel productivity and a lower US dollar average price for fuel. Income tax expense Depreciation and amortization The Company recorded income tax expense of $1,193 million for the year ended December 31, 2014, compared to $977 million in 2013. Depreciation and amortization expense increased by $70 million, Included in the 2014 figure was an income tax recovery of or 7%, in 2014 when compared to 2013. The increase was mainly $18 million resulting from a change in estimate of the deferred due to net capital additions, the negative translation impact of income tax liability related to properties. the weaker Canadian dollar, as well as the change in composite Included in the 2013 figures was a net income tax recovery of depreciation rates resulting from the 2013 depreciation study on $7 million consisting of a $24 million income tax expense resulting certain U.S. track and roadway properties, partly offset by some from the enactment of higher provincial corporate income tax rates; a asset impairments in 2013. Equipment rents $15 million income tax recovery resulting from the recognition of U.S. state income tax losses; and a $16 million income tax recovery resulting from a revision of the apportionment of U.S. state income taxes. Equipment rents expense increased by $54 million, or 20%, in The effective tax rate for 2014 was 27.4% compared to 27.2% 2014 when compared to 2013. The increase was primarily due in 2013. Excluding the net income tax recoveries of $18 million and to increased car hire expense due to higher volumes, the negative $7 million in 2014 and 2013, respectively, the effective tax rate for translation impact of the weaker Canadian dollar and higher costs 2014 was 27.8% compared to 27.4% in 2013. for the use of equipment from other railroads, partly offset by increased car hire income. CN | 2015 Annual Report 25 Management’s Discussion and Analysis Summary of quarterly financial data In millions, except per share data Fourth Third Second First Fourth Third Second First 2015 Quarters 2014 Quarters Revenues Operating income Net income Basic earnings per share Diluted earnings per share $ 3,166 $ 3,222 $ 3,125 $ 3,098 $ 3,207 $ 3,118 $ 3,116 $ 2,693 $ 1,354 $ 1,487 $ 1,362 $ 1,063 $ 1,260 $ 1,286 $ 1,258 $ 941 $ 1,007 $ 886 $ 704 $ 844 $ 853 $ 847 $ $ 820 623 $ 1.19 $ 1.26 $ 1.10 $ 0.87 $ 1.04 $ 1.04 $ 1.03 $ 0.75 $ 1.18 $ 1.26 $ 1.10 $ 0.86 $ 1.03 $ 1.04 $ 1.03 $ 0.75 Dividends per share $ 0.3125 $ 0.3125 $ 0.3125 $ 0.3125 $ 0.2500 $ 0.2500 $ 0.2500 $ 0.2500 Revenues generated by the Company during the year are influenced by seasonal weather conditions, general economic conditions, cyclical demand for rail transportation, and competitive forces in the transportation marketplace (see the section entitled Business risks of this MD&A). Operating expenses reflect the impact of freight volumes, seasonal weather conditions, labor costs, fuel prices, and the Company’s productivity initiatives. Fluctuations in the Canadian dollar relative to the US dollar have also affected the conversion of the Company’s US dollar-denominated revenues and expenses and resulted in fluctuations in net income in the rolling eight quarters presented above. The Company’s quarterly results include items that impacted the quarter-over-quarter comparability of the results of operations as presented below: In millions, except per share data Fourth Third Second First Fourth Third Second First 2015 Quarters 2014 Quarters Income tax expense (1) After-tax gain on disposal of property (2) Impact on net income Impact on basic earnings per share Impact on diluted earnings per share $ $ $ $ - - - - - $ $ $ $ - - - - - $ (42) $ - (42) (0.05) (0.05) $ $ $ $ $ $ - - - - - $ $ $ $ - - - - - $ $ $ $ - - - - - $ $ $ $ - - - - - $ $ - 72 72 $ 0.09 $ 0.09 (1) Income tax expense resulted from the enactment of a higher provincial corporate income tax rate. (2) In the first quarter of 2014, the Company sold the Deux-Montagnes for $97 million. A gain on disposal of $80 million ($72 million after-tax) was recognized in Other income. Summary of fourth quarter 2015 Fourth quarter 2015 net income was $941 million, an increase of $97 million, or 11%, when compared to the same period in 2014, with diluted earnings per share rising 15% to $1.18. Operating income for the quarter ended December 31, 2015 increased by $94 million, or 7%, to $1,354 million, when compared to the same period in 2014. The operating ratio was 57.2% in the fourth quarter of 2015 compared to 60.7% in the fourth quarter of 2014, a 3.5-point improvement. Revenues for the fourth quarter of 2015 decreased by $41 million, or 1%, to $3,166 million, when compared to the same period in 2014. The decrease was mainly attributable to reduced shipments of energy-related commodities due to a reduction in oil and gas activities, lower volumes of semi-finished steel products and short-haul iron ore, decreased shipments of coal due to weaker North American and global demand, and lower U.S. grain exports via the Gulf of Mexico; as well as a lower applicable fuel surcharge rate. These factors were partly offset by the positive translation impact of the weaker Canadian dollar on US dollar-denominated revenues, freight rate increases, and solid overseas intermodal demand. Fuel surcharge revenues decreased by $190 million in the fourth quarter of 2015, due to lower fuel surcharge rates and lower freight volumes, partly offset by the positive translation impact of the weaker Canadian dollar. Operating expenses for the fourth quarter of 2015 decreased by $135 million, or 7%, to $1,812 million, when compared to the same period in 2014. The decrease was primarily due to lower fuel expense, lower accident-related costs, and cost-management efforts, partly offset by the negative translation impact of a weaker Canadian dollar on US dollar-denominated expenses. 26 CN | 2015 Annual Report Management’s Discussion and Analysis Financial position The following tables provide an analysis of the Company’s balance sheet as at December 31, 2015 as compared to 2014. Assets and liabilities denominated in US dollars have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. As at December 31, 2015 and 2014, the foreign exchange rates were $1.3840 and $1.1601 per US$1.00, respectively. As a result of the retrospective adoption of new accounting standards in the fourth quarter of 2015, certain 2014 balances have been adjusted. Debt issuance costs have been reclassified from assets to Long-term debt and the current deferred income tax asset was reclassified as noncurrent and netted against the related noncurrent deferred income tax liability. See the section of this MD&A entitled Recent accounting pronouncements for additional information. In millions Total assets Variance mainly due to: Accounts receivable December 31, 2015 2014 Foreign exchange impact Variance excluding foreign exchange Explanation of variance, other than foreign exchange impact $ 36,402 $ 31,687 $ 2,761 $ 1,954 878 928 115 (165) Decrease due to the impact of an improved collection cycle. Properties 32,624 28,514 2,501 1,609 Pension asset 1,305 882 - 423 Total liabilities $ 21,452 $ 18,217 $ 2,506 $ 729 Variance mainly due to: Deferred income taxes 8,105 6,834 780 491 Pension and other postretirement benefits 720 650 35 35 Increase primarily due to gross property additions of $2,706 million, partly offset by depreciation of $1,158 million. Increase primarily due to the excess of the actual return on plan assets over current service cost and interest cost as well as the increase in the year-end discount rate from 3.87% in 2014 to 3.99% in 2015. Increase due to deferred income tax expense of $600 million recorded in Net income that was partly offset by a deferred income tax recovery of $105 mil- lion recorded in Other comprehensive income (loss). Increase primarily due to actuarial losses partly offset by the increase in the year-end discount rate from 3.87% in 2014 to 3.99% in 2015. In millions December 31, 2015 2014 Variance Explanation of variance Total shareholders’ equity $ 14,950 $ 13,470 $ 1,480 Variance mainly due to: Accumulated other comprehensive loss (1,767) (2,427) 660 Retained earnings 12,637 11,740 897 Decrease due to after-tax amounts of $230 million to recognize the funded status of the Company’s defined benefit pension and other postretirement benefit plans and $430 million for foreign exchange gains and other. Increase due to current year net income of $3,538 mil- lion, partly offset by share repurchases of $1,642 mil- lion and dividends paid of $996 million. CN | 2015 Annual Report 27 Management’s Discussion and Analysis Liquidity and capital resources The Company’s U.S. and other foreign subsidiaries hold cash to meet their respective operational requirements. The Company The Company’s principal source of liquidity is cash generated from can decide to repatriate funds associated with either undistributed operations, which is supplemented by borrowings in the money earnings or the liquidation of its foreign operations, including its markets and capital markets. To meet its short-term liquidity needs, U.S. and other foreign subsidiaries. Such repatriation of funds the Company has access to various financing sources, including a would not cause significant tax implications to the Company under committed revolving credit facility, a commercial paper program, and the tax treaties currently in effect between Canada and the U.S. an accounts receivable securitization program. In addition to these and other foreign tax jurisdictions. Therefore, the impact on liquidity sources, the Company can issue debt securities to meet its longer-term resulting from the repatriation of funds held outside Canada would liquidity needs. The Company’s access to long-term funds in the debt not be significant as the Company expects to continuously invest in capital markets depends on its credit rating and market conditions. these foreign jurisdictions. The Company believes that it continues to have access to the long- term debt capital markets. If the Company were unable to borrow The Company is not aware of any trends or expected fluctu- ations in its liquidity that would impact its ongoing operations or funds at acceptable rates in the long-term debt capital markets, the financial condition as at December 31, 2015. Company could borrow under its revolving credit facility, draw down on its accounts receivable securitization program, raise cash by dis- Available financing sources posing of surplus properties or otherwise monetizing assets, reduce Shelf prospectus and registration statement discretionary spending or take a combination of these measures to On January 5, 2016, the Company filed a new shelf prospectus with assure that it has adequate funding for its business. The strong focus the Canadian securities regulators and a registration statement with on cash generation from all sources gives the Company increased flexibility in terms of meeting its financing requirements. The Company’s primary uses of funds are for working capital requirements, including income tax installments, pension contri- butions, and contractual obligations; capital expenditures relating to track infrastructure and other; acquisitions; dividend payouts; and the repurchase of shares through share repurchase programs. the SEC, pursuant to which CN may issue up to $6.0 billion of debt securities in the Canadian and U.S. markets over the next 25 months. During 2015, the Company issued $850 million of debt under its previous shelf prospectus and registration statement, which expired in January 2016. As at December 31, 2015, the Company had issued $1.1 billion and US$600 million of debt under this shelf pro- spectus and registration statement, which provided for the issuance The Company sets priorities on its uses of available funds based on by CN of up to $3.0 billion of debt securities in the Canadian and short-term operational requirements, expenditures to continue to U.S. capital markets. operate a safe railway and pursue strategic initiatives, while also considering its long-term contractual obligations and returning value to its shareholders; and as part of its financing strategy, the Access to capital markets under the shelf prospectus and registration statement is dependent on market conditions. Company regularly reviews its optimal capital structure, cost of Revolving credit facility capital, and the need for additional debt financing. The Company’s revolving credit facility agreement provides access The Company has a working capital deficit, which is considered to $800 million of debt, with an accordion feature providing for common in the rail industry because it is capital-intensive, and not an additional $500 million subject to the consent of individual an indication of a lack of liquidity. The Company maintains adequate lenders. On March 12, 2015, the Company extended the term of its resources to meet daily cash requirements, and has sufficient financial capacity to manage its day-to-day cash requirements and current obligations. As at December 31, 2015 and December 31, 2014, the Company had Cash and cash equivalents of $153 million agreement by one year to May 5, 2020. The credit facility is avail- able for working capital and general corporate purposes, including backstopping the Company’s commercial paper programs. As at December 31, 2015 and December 31, 2014, the and $52 million, respectively; Restricted cash and cash equivalents Company had no outstanding borrowings under its revolving of $523 million and $463 million, respectively; and a working capital credit facility and there were no draws during the years ended deficit of $845 million and $208 million, respectively. The working December 31, 2015 and 2014. capital deficit increased by $637 million in 2015 primarily as a result of an increase in Current portion of long-term debt mainly due to Commercial paper the issuance of commercial paper; partly offset by increased Cash and cash equivalents and decreased Accounts payable and other. The Company has a commercial paper program in Canada and a new commercial paper program was established in the U.S. during The cash and cash equivalents pledged as collateral for a minimum the second quarter of 2015. Both programs are backstopped by the term of one month pursuant to the Company’s bilateral letter of Company’s revolving credit facility, enabling it to issue commercial credit facilities are recorded as Restricted cash and cash equivalents. paper up to a maximum aggregate principal amount of $800 mil- There are currently no specific requirements relating to working cap- lion, or the US dollar equivalent, on a combined basis. The program ital other than in the normal course of business as discussed herein. provides a flexible financing alternative for the Company, and is 28 CN | 2015 Annual Report Management’s Discussion and Analysis subject to market rates in effect at the time of financing. Access Bilateral letter of credit facilities to commercial paper is dependent on market conditions. If the The Company has a series of bilateral letter of credit facility agree- Company were to lose access to its commercial paper program for ments with various banks to support its requirements to post letters an extended period of time, the Company could rely on its $800 mil- of credit in the ordinary course of business. On March 12, 2015, the lion revolving credit facility to meet its short-term liquidity needs. Company extended the expiry date of its agreements by one year As at December 31, 2015, the Company had total commercial to April 28, 2018. Under these agreements, the Company has the paper borrowings of US$331 million ($458 million) (nil as at option from time to time to pledge collateral in the form of cash or December 31, 2014) presented in Current portion of long-term cash equivalents, for a minimum term of one month, equal to at debt on the Consolidated Balance Sheet. least the face value of the letters of credit issued. Accounts receivable securitization program drawn of $551 million ($487 million as at December 31, 2014) The Company has an agreement to sell an undivided co-ownership from a total committed amount of $575 million ($511 million as interest in a revolving pool of accounts receivable to unrelated trusts at December 31, 2014) by the various banks. As at December 31, for maximum cash proceeds of $450 million. On June 18, 2015, 2015, cash and cash equivalents of $523 million ($463 million as the Company extended the term of its agreement by one year to at December 31, 2014) were pledged as collateral and recorded February 1, 2018. The trusts are multi-seller trusts and the Company as Restricted cash and cash equivalents on the Consolidated As at December 31, 2015, the Company had letters of credit is not the primary beneficiary. Funding for the acquisition of these Balance Sheet. assets is customarily through the issuance of asset-backed commer- cial paper notes by the unrelated trusts. Additional information relating to these financing sources is pro- The Company has retained the responsibility for servicing, vided in Note 10 – Long-term debt to the Company’s 2015 Annual administering and collecting the receivables sold. The average ser- Consolidated Financial Statements. vicing period is approximately one month and is renewed at market rates in effect. Subject to customary indemnifications, each trust’s Credit ratings recourse is limited to the accounts receivable transferred. The Company’s ability to access funding in the debt capital markets The Company is subject to customary credit rating requirements, and the cost and amount of funding available depends in part on which if not met, could result in termination of the program. The its credit ratings. Rating downgrades could limit the Company’s necessary credit rating requirements have been met as of the date access to the capital markets, or increase its borrowing costs. The of this MD&A. The Company is also subject to customary reporting Company’s long-term debt rating was upgraded from A (low) to A requirements for which failure to perform could also result in by Dominion Bond Rating Service in 2015. termination of the program. The Company monitors the reporting The following table provides the credit ratings that CN has requirements and is currently not aware of any trends, events or received from credit rating agencies as of the date of this MD&A: conditions that could cause such termination. The accounts receivable securitization program provides the Company with readily available short-term financing for general corporate use. In the event the program is terminated before its scheduled maturity, the Company expects to meet its future pay- ment obligations through its various sources of financing including its revolving credit facility and commercial paper program, and/or access to capital markets. As at December 31, 2015, the Company had no proceeds ($50 million, which was secured by, and limited to, $56 million of accounts receivable as at December 31, 2014) received under the accounts receivable securitization program presented in Current portion of long-term debt on the Consolidated Balance Sheet. Dominion Bond Rating Service Moody’s Investors Service Standard & Poor’s Long-term debt rating Commercial paper rating A A2 A R-1 (low) P-1 A-1 These credit ratings are not recommendations to purchase, hold, or sell the securities referred to above. Ratings may be revised or withdrawn at any time by the credit rating agencies. Each credit rating should be evaluated independently of any other credit rating. CN | 2015 Annual Report 29 Management’s Discussion and Analysis Cash flows Investing activities Net cash used in investing activities increased by $651 million in 2015, mainly as a result of higher property additions. Property additions In millions Year ended December 31, 2015 2014 Track and roadway (1) Rolling stock Buildings Information technology Other Property additions $ 1,855 $ 1,604 480 71 144 156 325 104 144 120 $ 2,706 $ 2,297 (1) In both 2015 and 2014 approximately 90% of the Track and roadway property additions were incurred to renew the basic infrastructure. Costs relating to normal repairs and maintenance of Track and roadway properties are expensed as incurred, and amounted to approximately 12% of the Company’s total operating expenses in both 2015 and 2014. Capital expenditure program For 2016, the Company expects to invest approximately $2.9 billion in its capital program, which will be financed with cash generated from operations, as outlined below: • $1.5 billion on track infrastructure to continue operating a safe railway and improve the productivity and fluidity of the network; including the replacement of rail, ties, and other track materials, bridge improvements, as well as various branch line upgrades; • $0.6 billion on equipment capital expenditures, allowing the Company to tap growth opportunities and improve the quality of the fleet; and in order to handle expected traffic increase and improve operational efficiency, CN expects to take delivery of 90 new high-horsepower locomotives; • $0.4 billion on initiatives to drive productivity, including informa- tion technology to improve service and operating efficiency; and • $0.4 billion associated with the U.S. federal government legislative PTC implementation. Disposal of property There were no significant disposals of property in 2015. In 2014, cash inflows included proceeds of $76 million from the disposal of the Guelph and $97 million from the disposal of the Deux- Montagnes. Additional information relating to these disposals is provided in Note 3 – Other income to the Company’s 2015 Annual Consolidated Financial Statements. In millions Year ended December 31, 2015 2014 Variance Net cash provided by operating activities $ 5,140 $ 4,381 $ 759 Net cash used in investing activities (2,827) (2,176) Net cash used in financing activities (2,223) (2,370) (651) 147 Effect of foreign exchange fluctuations on US dollar-denominated cash and cash equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year 11 3 8 101 52 (162) 214 263 (162) Cash and cash equivalents, end of year $ 153 $ 52 $ 101 Operating activities Net cash provided by operating activities increased by $759 million in 2015, mainly due to higher operating income and improved collections. Pension contributions The Company’s contributions to its various defined benefit pension plans are made in accordance with the applicable legislation in Canada and the U.S. and such contributions follow minimum and maximum thresholds as determined by actuarial valuations. Pension contributions for the year ended December 31, 2015 and 2014 of $126 million and $127 million, respectively, primarily represent contributions to the CN Pension Plan, for the current service cost as determined under the Company’s current actuarial valuations for funding purposes. The Company expects to make total cash contribu- tions of approximately $115 million for all pension plans in 2016. See the section of this MD&A entitled Critical accounting estimates – Pensions and other postretirement benefits for additional information pertaining to the funding of the Company’s pension plans. Additional information relating to the pension plans is provided in Note 12 – Pensions and other postretirement benefits to the Company’s 2015 Annual Consolidated Financial Statements. Income tax payments The Company is required to make scheduled installment payments as prescribed by the tax authorities. In Canada, the Company’s domestic jurisdiction, tax installments in a given year are generally based on the prior year’s taxable income whereas in the U.S., the Company’s predominant foreign jurisdiction, they are based on forecasted taxable income of the current year. In 2015, net income tax payments were $725 million ($722 mil- lion in 2014). For the 2016 fiscal year, the Company’s net income tax payments are expected to be approximately $900 million. In 2016, U.S. tax payments will reflect the allowable 50% accelerated depreciation and the Railroad Track Maintenance Credit as extended by the Protecting Americans from Tax Hikes Act of 2015. The Company expects cash from operations and its other sources of financing to be sufficient to meet its funding obligations. 30 CN | 2015 Annual Report Management’s Discussion and Analysis Financing activities The following table provides the information related to the share Net cash used in financing activities decreased by $147 million in repurchase programs for the years ended December 31, 2015, 2014 2015, driven by higher share repurchases and dividend payments, and 2013: which were more than offset by a higher net issuance of debt, including commercial paper. Debt financing activities In millions, except per share data Year ended December 31, 2015 2014 Total 2013 program October 2015 - October 2016 program Debt financing activities in 2015 included the following: • On November 6, 2015, repayment of US$350 million ($461 mil- lion) Floating Rate Notes due 2015 upon maturity; Number of common shares (1) 5.8 Weighted-average price per share $ 70.44 Amount of repurchase $ 410 N/A N/A N/A N/A 5.8 N/A $ 70.44 N/A $ 410 • On September 22, 2015, issuance of $350 million 2.80% Notes October 2014 - October 2015 program due 2025, $400 million 3.95% Notes due 2045 and $100 mil- Number of common shares (1) 17.5 5.6 N/A 23.1 lion 4.00% Notes due 2065 in the Canadian capital markets, Weighted-average price per share (2) $ 76.79 $ 73.29 N/A $ 75.94 which resulted in total net proceeds of $841 million; and Amount of repurchase $ 1,340 $ 410 N/A $ 1,750 • Net issuance of commercial paper of $451 million. Debt financing activities in 2014 included the following: • On January 15, 2014, repayment of US$325 million ($356 mil- lion) 4.95% Notes due 2014 upon maturity; • On February 18, 2014, issuance of $250 million 2.75% Notes due 2021 in the Canadian capital markets, which resulted in net proceeds of $247 million; • On November 14, 2014, issuance of US$250 million ($284 mil- lion) Floating Rate Notes due 2017, and US$350 million ($398 million) 2.95% Notes due 2024, in the U.S. capital October 2013 - October 2014 program Number of common shares (1) N/A 16.8 5.5 22.3 Weighted-average price per share (2) N/A $ 65.40 $ 55.25 $ 62.88 Amount of repurchase N/A $ 1,095 $ 305 $ 1,400 Total for the year Number of common shares (1) 23.3 22.4 27.6 (4) Weighted-average price per share (2) $ 75.20 $ 67.38 $ 50.65 (4) Amount of repurchase (3) $ 1,750 $ 1,505 $ 1,400 (4) (1) Includes common shares repurchased in the first, third and fourth quarters of 2015, and the first and fourth quarters of 2014 and 2013 pursuant to private agreements between the Company and arm’s-length third-party sellers. markets, which resulted in total net proceeds of US$593 million (2) Includes brokerage fees. ($675 million); and • Net repayment of commercial paper of $277 million. (3) The 2015 common share repurchases include settlements in the subsequent period. (4) Includes 2013 repurchases from the October 2012 - October 2013 program, which consisted of 22.1 million common shares, a weighted-average price per share of $49.51 and an amount of repurchase of $1,095 million. Cash obtained from the issuance of debt in 2015 and 2014 was used for general corporate purposes, including the redemption and Share purchases by Share Trusts refinancing of outstanding indebtedness and share repurchases. In 2014, the Company established Employee Benefit Plan Trusts Additional information relating to the Company’s outstanding debt (“Share Trusts”) to purchase common shares on the open market, securities is provided in Note 10 – Long-term debt to the Company’s which will be used to deliver common shares under the Share Units 2015 Annual Consolidated Financial Statements. Share repurchase programs The Company may repurchase shares pursuant to a normal course issuer bid (NCIB) at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. Under its current NCIB, the Company may repurchase Plan. See Note 14 - Stock-based compensation to the Company’s 2015 Annual Consolidated Financial Statements for additional infor- mation on the Share Units Plan. For the year ended December 31, 2015, the Share Trusts purchased 1.4 million common shares for $100 million at a weighted-average price per share of $73.31, in- cluding brokerage fees. Additional information relating to the share purchases by Share Trusts is provided in Note 13 – Share capital to up to 33.0 million common shares between October 30, 2015 and the Company’s 2015 Annual Consolidated Financial Statements. October 29, 2016. Previous share repurchase programs allowed for the repurchase Dividends paid of up to 28.0 million common shares between October 24, 2014 and October 23, 2015, and up to 30.0 million common shares During 2015, the Company paid quarterly dividends of $0.3125 per share amounting to $996 million, compared to $818 million, between October 29, 2013 and October 23, 2014 pursuant to the at the rate of $0.2500 per share, in 2014. For 2016, the Company’s NCIBs. Board of Directors approved an increase of 20% to the quarterly dividend to common shareholders, from $0.3125 per share in 2015 to $0.3750 per share in 2016. CN | 2015 Annual Report 31 Management’s Discussion and Analysis Contractual obligations In the normal course of business, the Company incurs contractual obligations. The following table sets forth the Company’s contractual obligations for the following items as at December 31, 2015: In millions Debt obligations (1) Interest on debt obligations (2) Capital lease obligations (3) Operating lease obligations (4) Purchase obligations (5) Other long-term liabilities (6) Total contractual obligations Total 2016 2017 2018 2019 2020 2021 & thereafter $ 9,905 $ 1,219 $ 684 $ 720 $ 755 $ - $ 6,527 6,975 640 742 1,475 789 453 245 169 1,059 60 437 186 138 244 64 402 17 113 39 45 350 328 5,005 17 82 34 40 23 53 30 36 152 187 69 544 $ 20,526 $ 3,205 $ 1,753 $ 1,336 $ 1,278 $ 470 $ 12,484 (1) Presented net of unamortized discounts and debt issuance costs and excludes capital lease obligations of $522 million which are included in Capital lease obligations. (2) Interest payments on the floating rate notes are calculated based on the three-month London Interbank Offered Rate effective as at December 31, 2015. (3) Includes $522 million of minimum lease payments and $118 million of imputed interest at rates ranging from 0.7% to 7.3%. (4) Includes minimum rental payments for operating leases having initial non-cancelable lease terms of one year or more. The Company also has operating lease agreements for its automotive fleet with one-year non-cancelable terms for which its practice is to renew monthly thereafter. The estimated annual rental payments for such leases are approximately $20 million and generally extend over five years. (5) Includes commitments for railroad ties, rail, freight cars, locomotives and other equipment and services, and outstanding information technology service contracts and licenses. (6) Includes expected payments for workers’ compensation, postretirement benefits other than pensions, net unrecognized tax benefits, environmental liabilities, donations and pension obligations that have been classified as contractual settlement agreements. For 2016 and the foreseeable future, the Company expects cash flow from operations and from its various sources of financing to be sufficient to meet its debt repayments and future obligations, and to fund anticipated capital expenditures. Free cash flow standardized meaning prescribed by GAAP and therefore, may not Free cash flow is a non-GAAP measure that is reported as a sup- be comparable to similar measures presented by other companies. plementary indicator of the Company’s performance. Management believes that free cash flow is a useful measure of performance as In millions Year ended December 31, 2015 2014 it demonstrates the Company’s ability to generate cash for debt Net cash provided by operating activities obligations and for discretionary uses such as payment of dividends Net cash used in investing activities $ 5,140 $ 4,381 (2,827) (2,176) and strategic opportunities. The Company defines its free cash flow Net cash provided before financing activities 2,313 2,205 measure as the difference between net cash provided by operating activities and net cash used in investing activities; adjusted for changes in restricted cash and cash equivalents and the impact of major acquisitions, if any. Free cash flow does not have any Adjustment: Change in restricted cash and cash equivalents 60 15 Free cash flow $ 2,373 $ 2,220 32 CN | 2015 Annual Report Management’s Discussion and Analysis Credit measures All forward-looking information provided in this section is subject Management believes that the adjusted debt-to-total capitalization to risks and uncertainties and is based on assumptions about ratio is a useful credit measure that aims to show the true leverage events and developments that may not materialize or that may be of the Company. Similarly, the adjusted debt-to-adjusted earnings offset entirely or partially by other events and developments. before interest, income taxes, depreciation and amortization (EBITDA) multiple is another useful credit measure because it reflects the See the section of this MD&A entitled Forward-looking statements Company’s ability to service its debt. The Company excludes Other for a discussion of assumptions and risk factors affecting such income in the calculation of EBITDA. These measures do not have any forward-looking statements. standardized meaning prescribed by GAAP and therefore, may not be comparable to similar measures presented by other companies. Adjusted debt-to-total capitalization ratio Off balance sheet arrangements December 31, 2015 2014 Guarantees and indemnifications Debt-to-total capitalization ratio (1) (2) 41.1% 38.3% Add: Impact of present value of operating lease commitments (3) Adjusted debt-to-total capitalization ratio 1.4% 1.7% 42.5% 40.0% Adjusted debt-to-adjusted EBITDA multiple In millions, unless otherwise indicated Twelve months ended December 31, 2015 2014 In the normal course of business, the Company, including certain of its subsidiaries, enters into agreements that may involve providing guarantees or indemnifications to third parties and others, which may extend beyond the term of the agreements. These include, but are not limited to, residual value guarantees on operating leases, standby letters of credit, surety and other bonds, and indemnifi- cations that are customary for the type of transaction or for the railway business. As at December 31, 2015, the Company has not recorded a liability with respect to guarantees and indemnifications. Debt (2) $ 10,427 $ 8,372 Additional information relating to guarantees and indemnifications Add: Present value of operating lease commitments (3) 607 607 Adjusted debt Operating income Add: Depreciation and amortization EBITDA (excluding Other income) Add: Deemed interest on operating leases Adjusted EBITDA $ 11,034 $ 8,979 $ 5,266 $ 4,624 1,158 1,050 6,424 5,674 29 28 $ 6,453 $ 5,702 Adjusted debt-to-adjusted EBITDA multiple (times) 1.71 1.57 is provided in Note 16 – Major commitments and contingencies to the Company’s 2015 Annual Consolidated Financial Statements. Outstanding share data As at February 1, 2016, the Company had 784.6 million common shares and 5.8 million stock options outstanding. (1) Debt-to-total capitalization is calculated as total Long-term debt plus Current portion of long-term debt, divided by the sum of total debt plus Total shareholders’ equity. (2) As a result of the retrospective adoption of a new accounting standard in the fourth quarter of 2015, the 2014 debt balance has been adjusted and the related financial ratios have been restated. See the section of this MD&A entitled Recent accounting pronouncements for additional information. Financial instruments Risk management (3) The operating lease commitments have been discounted using the Company’s implicit In the normal course of business, the Company is exposed to interest rate for each of the periods presented. The increase in the Company’s adjusted debt-to-total capitalization ratio at December 31, 2015, as compared to 2014, was mainly due to an increased debt level, reflecting a weaker Canadian- to-US dollar foreign exchange rate in effect at the balance sheet date and the net issuance of debt, including commercial paper. The Company’s adjusted debt-to-adjusted EBITDA multiple also increased, which was driven by the increased debt level as at December 31, 2015, partly offset by a higher operating income earned during 2015, as compared to 2014. various risks from its use of financial instruments. To manage these risks, the Company follows a financial risk management framework, which is monitored and approved by the Company’s Finance Committee, with a goal of maintaining a strong balance sheet, optimizing earnings per share and free cash flow, financing its operations at an optimal cost of capital and preserving its liquidity. The Company has limited involvement with derivative financial instruments in the management of its risks and does not hold or issue them for trading or speculative purposes. CN | 2015 Annual Report 33 Management’s Discussion and Analysis Credit risk exchange rate between the Canadian dollar and the US dollar affect the Credit risk arises from cash and temporary investments, accounts Company’s revenues and expenses. To manage foreign currency risk, receivable and derivative financial instruments. To manage credit the Company designates US dollar-denominated long-term debt of the risk associated with cash and temporary investments, the Company parent company as a foreign currency hedge of its net investment in U.S. places these financial assets with governments, major financial subsidiaries. As a result, from the dates of designation, foreign exchange institutions, or other creditworthy counterparties; and performs gains and losses on translation of the Company’s US dollar-denominated ongoing reviews of these entities. To manage credit risk associated long-term debt are recorded in Accumulated other comprehensive loss, with accounts receivable, the Company reviews the credit history which minimizes volatility of earnings resulting from the conversion of US of each new customer, monitors the financial condition and dollar-denominated long-term debt into the Canadian dollar. credit limits of its customers, and keeps the average daily sales The Company also enters into foreign exchange forward contracts outstanding within an acceptable range. The Company works with to manage its exposure to foreign currency risk. As at December 31, customers to ensure timely payments, and in certain cases, requires 2015, the Company had outstanding foreign exchange forward con- financial security, including letters of credit. Although the Company tracts with a notional value of US$361 million (US$350 million as at believes there are no significant concentrations of customer credit December 31, 2014). Changes in the fair value of foreign exchange risk, economic conditions can affect the Company’s customers and forward contracts, resulting from changes in foreign exchange rates, can result in an increase to the Company’s credit risk and exposure are recognized in Other income in the Consolidated Statement of to business failures of its customers. A widespread deterioration Income as they occur. For the years ended December 31, 2015, 2014 of customer credit and business failures of customers could have and 2013, the Company recorded a gain of $61 million, $9 million, a material adverse effect on the Company’s results of operations, and $6 million, respectively, related to foreign exchange forward financial position or liquidity. The Company considers the risk due to contracts. These gains were largely offset by losses related to the the possible non-performance by its customers to be remote. re-measurement of other US dollar-denominated monetary assets The Company has limited involvement with derivative financial and liabilities recognized in Other income. As at December 31, instruments, however from time to time, it may enter into derivative 2015, Other current assets included an unrealized gain of $4 million financial instruments to manage its exposure to interest rates or ($9 million as at December 31, 2014) and Accounts payable and foreign currency exchange rates. To manage the counterparty risk other included an unrealized loss of $2 million (nil as at December 31, associated with the use of derivative financial instruments, the 2014), related to foreign exchange forward contracts. Company enters into contracts with major financial institutions that The estimated annual impact on net income of a year-over-year have been accorded investment grade ratings. Though the Company one-cent change in the Canadian dollar relative to the US dollar is is exposed to potential credit losses due to non-performance of approximately $30 million. these counterparties, the Company considers this risk remote. Interest rate risk Liquidity risk The Company is exposed to interest rate risk, which is the risk that the Liquidity risk is the risk that sufficient funds will not be available to fair value or future cash flows of a financial instrument will vary as a satisfy financial obligations as they come due. In addition to cash result of changes in market interest rates. Such risk exists in relation to generated from operations, which represents its principal source of li- the Company’s long-term debt. The Company mainly issues fixed-rate quidity, the Company manages liquidity risk by aligning other external debt, which exposes the Company to variability in the fair value of the sources of funds which can be obtained upon short notice, such as a debt. The Company also issues debt with variable interest rates, which committed revolving credit facility, commercial paper, and an accounts exposes the Company to variability in interest expense. receivable securitization program. As well, the Company can issue To manage interest rate risk, the Company manages its borrow- up to $6.0 billion of debt securities in the Canadian and U.S. capital ings in line with liquidity needs, maturity schedule, and currency markets, under its shelf prospectus and registration statement filed on and interest rate profile. In anticipation of future debt issuances, January 5, 2016. Access to capital markets under the shelf prospectus the Company may use derivative instruments such as forward rate and registration statement is dependent on market conditions. The agreements. The Company does not currently hold any significant Company believes that its investment grade credit ratings contribute derivative instruments to manage its interest rate risk. As at to reasonable access to capital markets. See the section of this MD&A December 31, 2015, Accumulated other comprehensive loss includ- entitled Liquidity and capital resources for additional information ed an unamortized gain of $7 million ($7 million as at December 31, relating to the Company’s available financing sources. 2014) relating to treasury lock transactions settled in a prior year, Foreign currency risk which is being amortized over the term of the related debt. The estimated annual impact on net income of a year-over-year The Company conducts its business in both Canada and the U.S. one-percent change in the interest rate on floating rate debt is and as a result, is affected by currency fluctuations. Changes in the approximately $10 million. 34 CN | 2015 Annual Report Management’s Discussion and Analysis Commodity price risk calculated using the average monthly price of On-Highway Diesel The Company is exposed to commodity price risk related to (OHD), and to a lesser extent West-Texas Intermediate crude oil (WTI). purchases of fuel and the potential reduction in net income due The Company also enters into agreements with fuel suppliers to increases in the price of diesel. Fuel prices are impacted by which allow but do not require the Company to purchase all of its geopolitical events, changes in the economy or supply disruptions. estimated 2016 volume, and approximately 25% of its anticipated Fuel shortages can occur due to refinery disruptions, production 2017 volume at market prices prevailing on the date of the purchase. quota restrictions, climate, and labor and political instability. While the Company’s fuel surcharge program provides effective The Company manages fuel price risk by offsetting the impact of coverage, residual exposure remains given that fuel price risk cannot rising fuel prices with the Company’s fuel surcharge program. The be completely managed due to timing and given the volatility in surcharge applied to customers is determined in the second calendar the market. As such, the Company may enter into derivative month prior to the month in which it is applied, and is generally instruments to manage such risk when considered appropriate. Fair value of financial instruments The following table provides the valuation methods and assumptions used by the Company to estimate the fair value of financial instruments and their associated level within the fair value hierarchy: Level 1 The carrying amounts of Cash and cash equivalents and Restricted cash and cash equivalents approximate fair value. Quoted prices for These financial instruments include highly liquid investments purchased three months or less from maturity, for identical instruments which the fair value is determined by reference to quoted prices in active markets. in active markets Level 2 The carrying amounts of Accounts receivable, Other current assets, and Accounts payable and other approximate Significant inputs fair value. The fair value of these financial instruments is not determined using quoted prices, but rather from (other than quoted market observable information. The fair value of derivative financial instruments used to manage the Company’s prices included exposure to foreign currency risk and included in Other current assets and Accounts payable and other is measured in Level 1) are by discounting future cash flows using a discount rate derived from market data for financial instruments subject to observable similar risks and maturities. The carrying amount of the Company’s debt does not approximate fair value. The fair value is estimated based on quoted market prices for the same or similar debt instruments, as well as discounted cash flows using current interest rates for debt with similar terms, company rating, and remaining maturity. As at December 31, 2015, the Company’s debt had a carrying amount of $10,427 million ($8,372 million as at December 31, 2014) and a fair value of $11,720 million ($9,767 million as at December 31, 2014). Level 3 The carrying amounts of investments included in Intangible and other assets approximate fair value, with the Significant inputs are exception of certain cost investments for which significant inputs are unobservable and fair value is estimated based unobservable on the Company’s proportionate share of the underlying net assets. As at December 31, 2015, the Company’s investments had a carrying amount of $69 million ($58 million as at December 31, 2014) and a fair value of $220 million ($183 million as at December 31, 2014). CN | 2015 Annual Report 35 Management’s Discussion and Analysis Recent accounting pronouncements The following recent Accounting Standards Updates (ASUs) issued by the Financial Accounting Standards Board (FASB) were adopted by the Company during the current period: Standard Description Impact ASU 2015-17 Simplifies the presentation of deferred income The Company adopted this standard during the fourth quarter Income Taxes, taxes by requiring that deferred tax liabilities and of 2015 on a retrospective basis. The current deferred income Balance Sheet assets be classified as noncurrent in a statement of tax asset was reclassified as noncurrent and netted against the Classification of financial position, thus eliminating the requirement related noncurrent deferred income tax liability in the amount of Deferred Taxes to separate deferred income tax liabilities and $58 million and $68 million as at December 31, 2015 and 2014, assets into current and noncurrent amounts. respectively. ASU 2015-03 Simplifies the presentation of debt issuance costs The Company adopted this standard during the fourth quarter of Interest – by requiring that such costs be presented in the 2015 on a retrospective basis. Debt issuance costs have been reclassi- Imputation of balance sheet as a deduction from the carrying fied from assets to Long-term debt in the amount of $42 million and Interest amount of debt. $37 million as at December 31, 2015 and 2014, respectively. The following recent ASUs issued by FASB have an effective date after December 31, 2015 and have not been adopted by the Company: Standard Description Impact Effective date (1) ASU 2016-01 Addresses certain aspects of recognition, measurement, The Company is December 15, 2017. Financial presentation, and disclosure of financial instruments. The evaluating the effect that Instruments – amendments require equity investments (except those accounted the ASU will have on its Overall for under the equity method of accounting or those resulting in Consolidated Financial consolidation) to be measured at fair value with changes in fair Statements, if any; value recognized in net income. The new guidance can be applied however, no significant by means of a cumulative effect adjustment to the balance sheet impact is expected. at the beginning of the year of adoption. ASU 2014-09 Establishes principles for reporting the nature, amount, timing and The Company is December 15, 2017. Revenue from uncertainty of revenues and cash flows arising from an entity’s evaluating the effect that Early adoption is Contracts with contracts with customers. The basis of the new standard is that the ASU will have on its permitted. Customers an entity recognizes revenue to represent the transfer of goods or Consolidated Financial services to customers in an amount that reflects the consideration Statements, if any; to which the entity expects to be entitled in exchange for those however, no significant goods or services. The new guidance can be applied using a impact is expected. retrospective or the cumulative effect transition method. (1) Effective for annual and interim reporting periods beginning after the stated date. 36 CN | 2015 Annual Report Management’s Discussion and Analysis Critical accounting estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions environment and concluded there are no significant impacts to its assertions for the realization of deferred income tax assets. In addition, Canadian, or domestic, tax rules and regulations, as well as those relating to foreign jurisdictions, are subject to that affect the reported amounts of revenues, expenses, assets and interpretation and require judgment by the Company that may be liabilities, and the disclosure of contingent assets and liabilities at challenged by the taxation authorities upon audit of the filed in- the date of the financial statements. On an ongoing basis, manage- come tax returns. Tax benefits are recognized if it is more likely than ment reviews its estimates based upon available information. Actual not that the tax position will be sustained on examination by the results could differ from these estimates. The Company’s policies for income taxes, depreciation, pensions and other postretirement taxation authorities. As at December 31, 2015, the total amount of gross unrecognized tax benefits was $27 million before considering benefits, personal injury and other claims and environmental matters, tax treaties and other arrangements between taxation authorities. require management’s more significant judgments and estimates in The amount of net unrecognized tax benefits as at December 31, the preparation of the Company’s consolidated financial statements 2015 was $19 million. If recognized, all of the net unrecognized and, as such, are considered to be critical. The following informa- tion should be read in conjunction with the Company’s 2015 Annual Consolidated Financial Statements and Notes thereto. Management discusses the development and selection of the tax benefits as at December 31, 2015 would affect the effective tax rate. The Company believes that it is reasonably possible that approximately $5 million of the net unrecognized tax benefits as at December 31, 2015 related to various federal, state, and provincial Company’s critical accounting estimates with the Audit Committee income tax matters, each of which are individually insignificant, may of the Company’s Board of Directors, and the Audit Committee has be recognized over the next twelve months as a result of settle- reviewed the Company’s related disclosures. Income taxes The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, the change in the net deferred income tax asset or liability is included in the ments and a lapse of the applicable statute of limitations. The Company’s deferred income tax assets are mainly composed of temporary differences related to the pension liability, accruals for personal injury claims and other reserves, other postretirement bene- fits liability, and net operating losses and tax credit carryforwards. The majority of these accruals will be paid out over the next five years. computation of Net income or Other comprehensive income (loss). The Company’s deferred income tax liabilities are mainly composed of Deferred income tax assets and liabilities are measured using temporary differences related to properties. The reversal of temporary enacted income tax rates expected to apply to taxable income in the differences is expected at future-enacted income tax rates which years in which temporary differences are expected to be recovered could change due to fiscal budget changes and/or changes in income or settled. As a result, a projection of taxable income is required for those years, as well as an assumption of the ultimate recovery/ settlement period for temporary differences. The projection of future taxable income is based on management’s best estimate and may vary from actual taxable income. tax laws. As a result, a change in the timing and/or the income tax rate at which the components will reverse, could materially affect deferred income tax expense as recorded in the Company’s results of operations. From time to time, the federal, provincial, and state governments enact new corporate income tax rates resulting in either On an annual basis, the Company assesses the need to establish lower or higher tax liabilities. A one-percentage-point change in a valuation allowance for its deferred income tax assets, and if it is deemed more likely than not that its deferred income tax either the Canadian or U.S. statutory federal tax rate would have the effect of changing the deferred income tax expense by approximately assets will not be realized, a valuation allowance is recorded. The $115 million. ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the per- iods in which those temporary differences become deductible. Management considers the scheduled reversals of deferred income tax liabilities, the available carryback and carryforward periods, and projected future taxable income in making this assessment. As at December 31, 2015, in order to fully realize all of the deferred income tax assets, the Company will need to generate future taxable income of approximately $2.2 billion and, based upon the level of historical taxable income and projections of future taxable For the year ended December 31, 2015, the Company recorded total income tax expense of $1,336 million, of which $600 million was a deferred income tax expense which included a deferred income tax expense of $42 million resulting from the enactment of a higher provincial corporate income tax rate. For the year ended December 31, 2014, the Company recorded total income tax expense of $1,193 million, of which $416 million was a deferred income tax expense which included an income tax recovery of $18 million resulting from a change in the estimate of the deferred income tax liability related to properties. For the year income over the periods in which the deferred income tax assets are ended December 31, 2013, the Company recorded total income tax deductible, management believes it is more likely than not that the expense of $977 million, of which $331 million was a deferred in- Company will realize the benefits of these deductible differences. Management has assessed the impacts of the current economic come tax expense and included a net income tax recovery of $7 mil- lion which consisted of a $15 million income tax recovery from the CN | 2015 Annual Report 37 Management’s Discussion and Analysis recognition of U.S. state income tax losses and a $16 million income the third quarter of 2015, the Company completed depreciation tax recovery from a revision of the apportionment of U.S. state studies for road properties and as a result, the Company changed income taxes, which were partly offset by a combined $24 million the estimated service lives for various types of road assets and income tax expense resulting from the enactment of higher their related composite depreciation rates. The results of these provincial corporate income tax rates. The Company’s net deferred depreciation studies did not materially affect the Company’s annual income tax liability as at December 31, 2015 was $8,105 million depreciation expense. ($6,834 million as at December 31, 2014). Additional disclosures In 2015, the Company recorded total depreciation expense are provided in Note 4 – Income taxes to the Company’s 2015 of $1,156 million ($1,050 million in 2014 and $979 million in Annual Consolidated Financial Statements. 2013). As at December 31, 2015, the Company had Properties of Depreciation $32,624 million, net of accumulated depreciation of $12,203 mil- lion ($28,514 million, net of accumulated depreciation of Properties are carried at cost less accumulated depreciation includ- $11,195 million, as at December 31, 2014). Additional disclosures ing asset impairment write-downs. The cost of properties, including are provided in Note 7 – Properties to the Company’s 2015 Annual those under capital leases, net of asset impairment write-downs, Consolidated Financial Statements. is depreciated on a straight-line basis over their estimated service U.S. GAAP requires the use of historical cost as the basis of lives, measured in years, except for rail which is measured in millions reporting in financial statements. As a result, the cumulative effect of gross ton miles. The Company follows the group method of of inflation, which has significantly increased asset replacement depreciation whereby a single composite depreciation rate is applied costs for capital-intensive companies such as CN, is not reflected in to the gross investment in a class of similar assets, despite small operating expenses. Depreciation charges on an inflation-adjusted differences in the service life or salvage value of individual property basis, assuming that all operating assets are replaced at current units within the same asset class. The Company uses approximately price levels, would be substantially greater than historically reported 40 different depreciable asset classes. amounts. For all depreciable assets, the depreciation rate is based on the estimated service lives of the assets. Assessing the reasonableness Pensions and other postretirement benefits of the estimated service lives of properties requires judgment and is The Company’s plans have a measurement date of December 31. based on currently available information, including periodic depreci- The following table provides the Company’s pension asset, ation studies conducted by the Company. The Company’s U.S. prop- pension liability and other postretirement benefits liability as at erties are subject to comprehensive depreciation studies as required December 31, 2015 and 2014: by the Surface Transportation Board (STB) and are conducted by external experts. Depreciation studies for Canadian properties are In millions December 31, 2015 2014 not required by regulation and are conducted internally. Studies are Pension asset performed on specific asset groups on a periodic basis. Changes in Pension liability the estimated service lives of the assets and their related composite Other postretirement benefits liability $ 1,305 $ 882 469 269 400 267 depreciation rates are implemented prospectively. The studies consider, among other factors, the analysis of historical retirement data using recognized life analysis techniques, and the forecasting of asset life characteristics. Changes in circum- stances, such as technological advances, changes to the Company’s business strategy, changes in the Company’s capital strategy or changes in regulations can result in the actual service lives differing from the Company’s estimates. A change in the remaining service life of a group of assets, or their estimated net salvage value, will affect the depreciation rate used to amortize the group of assets and thus affect depreciation expense as reported in the Company’s results of operations. A change of one year in the composite service life of the Company’s fixed asset base would impact annual depreciation expense by approximately $30 million. Depreciation studies are a means of ensuring that the assump- tions used to estimate the service lives of particular asset groups are still valid and where they are not, they serve as the basis to establish the new depreciation rates to be used on a prospective basis. In The descriptions in the following paragraphs pertaining to pensions relate generally to the Company’s main pension plan, the CN Pension Plan, unless otherwise specified. Calculation of net periodic benefit cost (income) In accounting for pensions and other postretirement benefits, assumptions are required for, among other things, the discount rate, the expected long-term rate of return on plan assets, the rate of compensation increase, health care cost trend rates, mortality rates, employee early retirements, terminations and disability. Changes in these assumptions result in actuarial gains or losses, which are recognized in Other comprehensive income (loss). The Company generally amortizes these gains or losses into net periodic benefit cost over the expected average remaining service life of the employee group covered by the plans only to the extent that the unrecognized net actuarial gains and losses are in excess of the corridor threshold, which is calculated as 10% of the greater of the beginning-of-year balances of the projected benefit obligation 38 CN | 2015 Annual Report Management’s Discussion and Analysis or market-related value of plan assets. The Company’s net periodic rate used to measure the projected benefit obligation at the benefit cost for future periods is dependent on demographic beginning of the period. experience, economic conditions and investment performance. The spot rate approach enhances the precision to which current Recent demographic experience has revealed no material net service cost and interest cost are measured by increasing the gains or losses on termination, retirement, disability and mortality. correlation between projected cash flows and spot discount rates Experience with respect to economic conditions and investment corresponding to their maturity. Under the spot rate approach, performance is further discussed herein. individual spot discount rates along the same yield curve used in the For the years ended December 31, 2015, 2014 and 2013, the determination of the projected benefit obligation are applied to the consolidated net periodic benefit cost (income) for pensions and relevant projected cash flows at the relevant maturity. More specific- other postretirement benefits were as follows: ally, current service cost is measured using the projected cash flows In millions Year ended December 31, 2015 2014 2013 Net periodic benefit cost (income) for pensions $ 34 $ (4) $ 90 Net periodic benefit cost for other postretirement benefits 10 12 14 As at December 31, 2015 and 2014, the projected pension benefit obligation and accumulated other postretirement benefit obligation were as follows: related to benefits expected to be accrued in the following year by active members of a plan and interest cost is measured using the projected cash flows making up the projected benefit obligation multiplied by the corresponding spot discount rate at each maturity. Use of the spot rate approach does not affect the measurement of the projected benefit obligation. Based on bond yields prevailing at December 31, 2015, the single equivalent discount rates to determine current service cost and interest cost under the spot rate approach in 2016 are 4.24% and 3.27%, respectively, compared to 3.99%, for both costs, under In millions December 31, 2015 2014 the approach applicable in 2015 and prior years. For 2016, the Projected pension benefit obligation $ 17,081 $ 17,279 Accumulated other postretirement benefit obligation 269 267 Discount rate assumption The Company’s discount rate assumption, which is set annually at the end of each year, is used to determine the projected benefit obligation at the end of the year and net periodic benefit cost (in- come) for the following year. The discount rate is used to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments with a rating of AA or better, would provide the necessary cash flows to pay for pension benefits as they become due. The discount rate is determined by management with the aid of third-party actuaries. For the Canadian pension and other postretirement benefit plans, future expected benefit payments at each measurement date are discounted using spot rates from a derived AA corporate bond yield curve. The derived curve is based on observed rates for AA corporate bonds with short-term maturities and a projected AA corporate curve for longer-term maturities based on spreads between observed AA corporate bonds and AA provincial bonds. The derived curve is expected to generate cash flows that match the estimated future benefit payments of the plans as the bond rate for each maturity year is applied to the plans’ corresponding expected benefit pay- ments of that year. A discount rate of 3.99%, based on bond yields prevailing at December 31, 2015 (3.87% at December 31, 2014) was considered appropriate by the Company. Beginning in 2016, the Company will adopt the spot rate approach to measure current service cost and interest cost for all defined benefit pension and other postretirement benefit plans on a prospective basis as a change in accounting estimate. In 2015 and in prior years, these costs were determined using the discount Company estimates the adoption of the spot rate approach will increase net periodic benefit income by approximately $120 million compared to the approach applicable in 2015 and prior years. For the year ended December 31, 2015, a 0.25% decrease in the 3.99% discount rate used to determine the projected benefit obliga- tion would have resulted in a decrease of approximately $495 million to the funded status for pensions and would result in a decrease of approximately $20 million to the 2016 projected net periodic benefit income. A 0.25% increase in the discount rate would have resulted in an increase of approximately $475 million to the funded status for pensions and would result in an increase of approximately $20 mil- lion to the 2016 projected net periodic benefit income. Expected long-term rate of return assumption To develop its expected long-term rate of return assumption used in the calculation of net periodic benefit cost applicable to the market-related value of assets, the Company considers multiple factors. The expected long-term rate of return is determined based on expected future performance for each asset class and is weighted based on the current asset portfolio mix. Consideration is taken of the historical performance, the premium return generated from an actively managed portfolio, as well as current and future anticipated asset allocations, economic developments, inflation rates and administrative expenses. Based on these factors, the rate is determined by the Company. For 2015, the Company used a long-term rate of return assumption of 7.00% on the market-related value of plan assets to compute net periodic benefit cost. For 2016, the Company will maintain the expected long-term rate of return on plan assets at 7.00% to reflect management’s current view of long-term investment returns. The Company has elected to use a market-related value of assets, whereby realized and unrealized CN | 2015 Annual Report 39 Management’s Discussion and Analysis gains/losses and appreciation/depreciation in the value of the invest- Net periodic benefit income for pensions for 2016 ments are recognized over a period of five years, while investment In 2016, the Company expects net periodic benefit income of income is recognized immediately. If the Company had elected to approximately $120 million for all its defined benefit pension plans. use the market value of assets, which for the CN Pension Plan at The favorable variance compared to 2015 is primarily due to lower December 31, 2015 was above the market-related value of assets current service cost and interest cost resulting from the adoption of by approximately $1,760 million, the projected net periodic benefit the spot rate approach as well as lower amortization of actuarial losses income for 2016 would increase by approximately $270 million. resulting from the increase in the discount rate from 3.87% to 3.99%. The assets of the Company’s various plans are held in separate trust funds (“Trusts”) which are diversified by asset type, country and investment strategies. Each year, the CN Board of Directors re- views and confirms or amends the Statement of Investment Policies and Procedures (SIPP) which includes the plans’ long-term asset mix target and related benchmark indices (“Policy”). This Policy is based on a long-term forward-looking view of the world economy, the dynamics of the plans’ benefit liabilities, the market return expectations of each asset class and the current state of financial markets. The target long-term asset mix in 2015 was: 3% cash and short-term investments, 37% bonds and mortgages, 45% equities, 4% real estate, 7% oil and gas and 4% infrastructure investments. Annually, the CN Investment Division (“Investment Manager”), a division of the Company created to invest and administer the assets of the plans, proposes a short-term asset mix target (“Strategy”) for the coming year, which is expected to differ from the Policy, because of current economic and market conditions and expect- ations. The Investment Committee of the Board (“Committee”) regularly compares the actual asset mix to the Policy and Strategy and compares the actual performance of the Company’s pension plans to the performance of the benchmark indices. The Committee’s approval is required for all major investments in illiquid securities. The SIPP allows for the use of derivative financial instruments to implement strategies or to hedge or adjust existing or anticipated exposures. The SIPP prohibits investments in securities of the Company or its subsidiaries. During the last 10 years ended December 31, 2015, the CN Pension Plan earned an annual average rate of return of 6.06%. The actual, market-related value, and expected rates of return on plan assets for the last five years were as follows: Plan asset allocation Based on the fair value of the assets held as at December 31, 2015, the assets of the Company’s various plans are comprised of 2% in cash and short-term investments, 30% in bonds and mortgages, 40% in equi- ties, 2% in real estate assets, 5% in oil and gas, 7% in infrastructure, 11% in absolute return investments, and 3% in risk-based allocation investments. See Note 12 - Pensions and other postretirement benefits to the Company’s 2015 Annual Consolidated Financial Statements for information on the fair value measurements of such assets. A significant portion of the plans’ assets are invested in publicly traded equity securities whose return is primarily driven by stock market performance. Debt securities also account for a significant portion of the plans’ investments and provide a partial offset to the variation in the pension benefit obligation that is driven by changes in the discount rate. The funded status of the plan fluctuates with market conditions and impacts funding requirements. The Company will continue to make contributions to the pension plans that as a minimum meet pension legislative requirements. Rate of compensation increase and health care cost trend rate The rate of compensation increase is determined by the Company based upon its long-term plans for such increases. For 2015, a basic rate of compensation increase of 2.75% was used to determine the projected benefit obligation and 3.00% for the net periodic benefit cost. For postretirement benefits other than pensions, the Company reviews external data and its own historical trends for health care costs to determine the health care cost trend rates. For measurement purposes, the projected health care cost trend rate was assumed to be 6.5% in 2015, and it is assumed that the rate will decrease 2015 2014 2013 2012 2011 gradually to 4.5% in 2028 and remain at that level thereafter. Actual 5.5% 10.1% 11.2% Market-related value 7.0% 7.6% 7.3% 7.7% 2.3% 0.3% 3.0% Expected 7.00% 7.00% 7.00% 7.25% 7.50% For the year ended December 31, 2015, a one-percentage-point change in either the rate of compensation increase or the health care cost trend rate would not cause a material change to the Company’s net periodic benefit cost for both pensions and other The Company’s expected long-term rate of return on plan assets postretirement benefits. reflects management’s view of long-term investment returns and the effect of a 1% variation in such rate of return would result in a change to the net periodic benefit cost of approximately $90 million. Management’s assumption of the expected long-term rate of return is subject to risks and uncertainties that could cause the actual rate of return to differ materially from management’s assumption. There can be no assurance that the plan assets will be able to earn the expected long-term rate of return on plan assets. Mortality The Canadian Institute of Actuaries (CIA) published in 2014 a report on Canadian Pensioners’ Mortality (“Report”). The Report contained Canadian pensioners’ mortality tables and improvement scales based on experience studies conducted by the CIA. The CIA’s conclusions were taken into account in selecting management’s best estimate mortality assumption used to calculate the projected benefit obligation as at December 31, 2015 and 2014. 40 CN | 2015 Annual Report Management’s Discussion and Analysis Funding of pension plans December 31, 2014 indicated a funding excess on a going concern The Company’s main Canadian defined benefit pension plan, basis of approximately $1.9 billion and a funding deficit on a sol- the CN Pension Plan, accounts for approximately 92% of the vency basis of approximately $0.7 billion, calculated using the three- Company’s pension obligation and can produce significant volatility year average of the plans’ hypothetical wind-up ratio in accordance in pension funding requirements, given the pension fund’s size, with the Pension Benefit Standards Regulations, 1985. The federal the many factors that drive the plan’s funded status, and Canadian pension legislation requires funding deficits, as calculated under statutory pension funding requirements. Adverse changes to the current pension regulations, to be paid over a number of years. assumptions used to calculate the plan’s funding status, particularly Alternatively, a letter of credit can be subscribed to fulfill required the discount rate used for funding purposes, as well as changes to solvency deficit payments. existing federal pension legislation, regulation and guidance could The Company’s next actuarial valuations for its Canadian significantly impact the Company’s future contributions. registered pension plans required as at December 31, 2015 will For accounting purposes, the funded status is calculated under be performed in 2016. These actuarial valuations are expected to generally accepted accounting principles for all pension plans. identify a funding excess on a going concern basis of approximately For funding purposes, the funded status is also calculated under $2.3 billion, while on a solvency basis a funding excess of approxi- going concern and solvency scenarios as prescribed under pension mately $0.2 billion is expected. Based on the anticipated results of legislation and subject to guidance issued by the CIA and the these valuations, the Company expects to make total cash contri- Office of the Superintendent of Financial Institutions (OSFI) for all butions of approximately $115 million for all of the Company’s registered Canadian defined benefit pension plans. The Company’s pension plans in 2016. The Company expects cash from operations funding requirements are determined upon completion of actuarial and its other sources of financing to be sufficient to meet its 2016 valuations. Actuarial valuations are generally required on an annual funding obligations. basis for all Canadian plans, or when deemed appropriate by See the section of this MD&A entitled Liquidity and capital the OSFI. Actuarial valuations are also required annually for the resources – Pension contributions for additional information relating Company’s U.S. qualified pension plans. to pension contributions. The Company’s latest actuarial valuations for funding pur- poses of its Canadian registered pension plans conducted as at Information disclosed by major pension plan The following table provides the Company’s plan assets by category, projected benefit obligation at end of year, as well as Company and employee contributions by major defined benefit pension plan: In millions Plan assets by category Cash and short-term investments Bonds Mortgages Equities Real estate Oil and gas Infrastructure Absolute return Risk-based allocation Other (1) Total plan assets Projected benefit obligation at end of year Company contributions in 2015 Employee contributions in 2015 December 31, 2015 CN Pension Plan BC Rail Pension Plan U.S. and other plans Total $ 346 $ 14 $ 29 $ 389 4,969 122 6,766 345 976 1,194 1,847 407 66 200 4 215 11 31 38 59 13 3 $ 17,038 $ 15,794 $ $ 588 532 $ $ 78 58 - - 104 1 126 1 5 5 8 2 10 291 755 30 - 5,273 127 7,107 357 1,012 1,237 1,914 422 79 $ 17,917 $ 17,081 108 58 (1) Other consists of operating assets of $119 million and liabilities of $40 million required to administer the Trusts’ investment assets and the plans’ benefit and funding activities. Additional disclosures are provided in Note 12 – Pensions and other postretirement benefits to the Company’s 2015 Annual Consolidated Financial Statements. CN | 2015 Annual Report 41 Management’s Discussion and Analysis Personal injury and other claims United States In the normal course of business, the Company becomes involved Personal injury claims by the Company’s employees, including claims in various legal actions seeking compensatory and occasionally alleging occupational disease and work-related injuries, are subject punitive damages, including actions brought on behalf of various to the provisions of the Federal Employers’ Liability Act (FELA). purported classes of claimants and claims relating to employee and Employees are compensated under FELA for damages assessed third-party personal injuries, occupational disease and property based on a finding of fault through the U.S. jury system or through damage, arising out of harm to individuals or property allegedly individual settlements. As such, the provision is undiscounted. With caused by, but not limited to, derailments or other accidents. limited exceptions where claims are evaluated on a case-by-case Canada basis, the Company follows an actuarial-based approach and accrues the expected cost for personal injury, including asserted Employee injuries are governed by the workers’ compensation legis- and unasserted occupational disease claims, and property damage lation in each province whereby employees may be awarded either claims, based on actuarial estimates of their ultimate cost. A a lump sum or a future stream of payments depending on the comprehensive actuarial study is performed annually. nature and severity of the injury. As such, the provision for employee For employee work-related injuries, including asserted occupa- injury claims is discounted. In the provinces where the Company tional disease claims, and third-party claims, including grade cross- is self-insured, costs related to employee work-related injuries are ing, trespasser and property damage claims, the actuarial valuation accounted for based on actuarially developed estimates of the considers, among other factors, the Company’s historical patterns ultimate cost associated with such injuries, including compensation, of claims filings and payments. For unasserted occupational disease health care and third-party administration costs. A comprehensive claims, the actuarial study includes the projection of the Company’s actuarial study is generally performed at least on a triennial basis. experience into the future considering the potentially exposed For all other legal actions, the Company maintains, and regularly population. The Company adjusts its liability based upon manage- updates on a case-by-case basis, provisions for such items when ment’s assessment and the results of the study. On an ongoing the expected loss is both probable and can be reasonably estimated basis, management reviews and compares the assumptions inherent based on currently available information. in the latest actuarial study with the current claim experience and, In 2015, the Company recorded a $12 million decrease to its if required, adjustments to the liability are recorded. provision for personal injuries and other claims in Canada as a result Due to the inherent uncertainty involved in projecting future of a comprehensive actuarial study for employee injury claims as events, including events related to occupational diseases, which well as various other claims. In 2014 and 2013, external actuarial include but are not limited to, the timing and number of actual studies resulted in a net decrease of $2 million and a net increase claims, the average cost per claim and the legislative and judicial of $1 million, respectively. environment, the Company’s future payments may differ from As at December 31, 2015, 2014 and 2013 the Company’s provi- current amounts recorded. sion for personal injury and other claims in Canada was as follows: In 2015, the Company recorded a $5 million reduction to its provision for U.S. personal injury and other claims attributable to non-occupational disease claims, third-party claims and occu- pational disease claims pursuant to the 2015 external actuarial study. In 2014 and 2013, external actuarial studies resulted in a net decrease of $20 million and $11 million, respectively. The prior years’ decreases from the 2014 and 2013 actuarial valuations were mainly attributable to non-occupational disease claims, third-party claims and occupational disease claims, reflecting a decrease in the Company’s estimates of unasserted claims and costs related to asserted claims. The Company has an ongoing risk mitigation strategy focused on reducing the frequency and severity of claims through injury prevention and containment; mitigation of claims; and lower settlements of existing claims. In millions 2015 2014 2013 Beginning of year Accruals and other Payments End of year Current portion - End of year $ 203 $ 210 $ 209 17 (29) 28 (35) $ 191 $ 27 $ 203 $ 28 38 (37) $ 210 $ 31 The assumptions used in estimating the ultimate costs for Canadian employee injury claims include, among other factors, the discount rate, the rate of inflation, wage increases and health care costs. The Company periodically reviews its assumptions to reflect currently available information. Over the past three years, the Company has not significantly changed any of these assump- tions. Changes in any of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. For all other legal claims in Canada, estimates are based on the specifics of the case, trends and judgment. 42 CN | 2015 Annual Report Management’s Discussion and Analysis As at December 31, 2015, 2014 and 2013, the Company’s efforts are probable, and when the costs, based on a specific plan provision for personal injury and other claims in the U.S. was as of action in terms of the technology to be used and the extent of follows: In millions 2015 2014 2013 Beginning of year $ 95 $ 106 $ 105 Accruals and other Payments Foreign exchange End of year Current portion - End of year 22 (30) 18 2 (22) 9 18 (24) 7 $ 105 $ 24 $ 95 $ 20 $ 106 $ 14 For the U.S. personal injury and other claims liability, histor- ical claim data is used to formulate assumptions relating to the expected number of claims and average cost per claim for each year. Changes in any one of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. A 5% change in the asbestos average claim cost or a 1% change in the inflation trend rate for all injury types would result in an increase or decrease in the liability recorded of approximately $2 million. the corrective action required, can be reasonably estimated. The Company estimates the costs related to a particular site using cost scenarios established by external consultants based on the extent of contamination and expected costs for remedial efforts. In the case of multiple parties, the Company accrues its allocable share of liability taking into account the Company’s alleged responsibility, the number of potentially responsible parties and their ability to pay their respective share of the liability. Adjustments to initial estimates are recorded as additional information becomes available. The Company’s provision for specific environmental sites is undiscounted and includes costs for remediation and restoration of sites, as well as monitoring costs. Environmental expenses, which are classified as Casualty and other in the Consolidated Statement of Income, include amounts for newly identified sites or contam- inants as well as adjustments to initial estimates. Recoveries of environmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. As at December 31, 2015, 2014 and 2013, the Company’s provision for specific environmental sites was as follows: Environmental matters Known existing environmental concerns The Company has identified approximately 215 sites at which it is or may be liable for remediation costs, in some cases along with other potentially responsible parties, associated with alleged contamination and is subject to environmental clean-up and enforcement actions, including those imposed by the United States Federal Comprehensive Environmental Response, Compensation, In millions Beginning of year Accruals and other Payments Foreign exchange End of year Current portion - End of year 2015 2014 2013 $ 114 $ 119 $ 123 81 (91) 6 11 (19) 3 12 (18) 2 $ 110 $ 51 $ 114 $ 45 $ 119 $ 41 and Liability Act of 1980 (CERCLA), also known as the Superfund The Company anticipates that the majority of the liability at law, or analogous state laws. CERCLA and similar state laws, in December 31, 2015 will be paid out over the next five years. addition to other similar Canadian and U.S. laws, generally impose However, some costs may be paid out over a longer period. Based joint and several liability for clean-up and enforcement costs on on the information currently available, the Company considers its current and former owners and operators of a site, as well as those provisions to be adequate. whose waste is disposed of at the site, without regard to fault or the legality of the original conduct. The Company has been notified Unknown existing environmental concerns that it is a potentially responsible party for study and clean-up costs While the Company believes that it has identified the costs likely to be at 6 sites governed by the Superfund law (and analogous state incurred for environmental matters based on known information, the laws) for which investigation and remediation payments are or will discovery of new facts, future changes in laws, the possibility of releases be made or are yet to be determined and, in many instances, is one of hazardous materials into the environment and the Company’s of several potentially responsible parties. ongoing efforts to identify potential environmental liabilities that may The ultimate cost of addressing these known contaminated sites be associated with its properties may result in the identification of cannot be definitively established given that the estimated environ- additional environmental liabilities and related costs. The magnitude mental liability for any given site may vary depending on the nature of such additional liabilities and the costs of complying with future and extent of the contamination; the nature of anticipated response environmental laws and containing or remediating contamination actions, taking into account the available clean-up techniques; cannot be reasonably estimated due to many factors, including: evolving regulatory standards governing environmental liability; and • the lack of specific technical information available with respect the number of potentially responsible parties and their financial to many sites; viability. As a result, liabilities are recorded based on the results of a • the absence of any government authority, third-party orders, or four-phase assessment conducted on a site-by-site basis. A liability is claims with respect to particular sites; initially recorded when environmental assessments occur, remedial CN | 2015 Annual Report 43 Management’s Discussion and Analysis • the potential for new or changed laws and regulations and for existing systems and/or processes. Other capital expenditures development of new remediation technologies and uncertainty relate to assessing and remediating certain impaired properties. regarding the timing of the work with respect to particular The Company’s environmental capital expenditures amounted to sites; and $18 million in 2015, $19 million in 2014 and $10 million in 2013. • the determination of the Company’s liability in proportion to For 2016, the Company expects to incur capital expenditures other potentially responsible parties and the ability to recover relating to environmental matters in the same range as 2015. costs from any third parties with respect to particular sites. Therefore, the likelihood of any such costs being incurred or whether Business risks such costs would be material to the Company cannot be determined at this time. There can thus be no assurance that liabilities or costs In the normal course of business, the Company is exposed to related to environmental matters will not be incurred in the future, various business risks and uncertainties that can have an effect on or will not have a material adverse effect on the Company’s financial the Company’s results of operations, financial position, or liquidity. position or results of operations in a particular quarter or fiscal year, While some exposures may be reduced by the Company’s risk or that the Company’s liquidity will not be adversely impacted by management strategies, many risks are driven by external factors such liabilities or costs, although management believes, based on beyond the Company’s control or are of a nature which cannot current information, that the costs to address environmental matters be eliminated. The key areas of business risks and uncertainties will not have a material adverse effect on the Company’s financial described in this section are not the only ones that can affect the position or liquidity. Costs related to any unknown existing or future Company. Additional risks and uncertainties not currently known to contamination will be accrued in the period in which they become management or that may currently not be considered material by probable and reasonably estimable. management, could nevertheless also have an adverse effect on the Future occurrences In railroad and related transportation operations, it is possible that Competition Company’s business. derailments or other accidents, including spills and releases of hazard- The Company faces significant competition, including from rail ous materials, may occur that could cause harm to human health or carriers and other modes of transportation, and is also affected to the environment. As a result, the Company may incur costs in the by its customers’ flexibility to select among various origins and future, which may be material, to address any such harm, compliance destinations, including ports, in getting their products to market. with laws and other risks, including costs relating to the performance Specifically, the Company faces competition from Canadian Pacific of clean-ups, payment of environmental penalties and remediation Railway Company, which operates the other major rail system in obligations, and damages relating to harm to individuals or property. Canada and services most of the same industrial areas, commodity Regulatory compliance resources and population centers as the Company; major U.S. railroads and other Canadian and U.S. railroads; long-distance The Company may incur significant capital and operating costs trucking companies, transportation via the St. Lawrence-Great Lakes associated with environmental regulatory compliance and clean- Seaway and the Mississippi River and transportation via pipelines. up requirements, in its railroad operations and relating to its past In addition, while railroads must build or acquire and maintain their and present ownership, operation or control of real property. rail systems, motor carriers and barges are able to use public rights- Environmental expenditures that relate to current operations are of-way that are built and maintained by public entities without expensed unless they relate to an improvement to the property. paying fees covering the entire costs of their usage. Expenditures that relate to an existing condition caused by past Competition is generally based on the quality and the reliability operations and which are not expected to contribute to current or of the service provided, access to markets, as well as price. Factors future operations are expensed. Operating expenses for environ- affecting the competitive position of customers, including exchange mental matters amounted to $20 million in 2015, $20 million in rates and energy cost, could materially adversely affect the demand 2014 and $18 million in 2013. For 2016, the Company expects to for goods supplied by the sources served by the Company and, incur operating expenses relating to environmental matters in the therefore, the Company’s volumes, revenues and profit margins. same range as 2015. In addition, based on the results of its oper- Factors affecting the general market conditions for the Company’s ations and maintenance programs, as well as ongoing environment- customers can result in an imbalance of transportation capacity rela- al audits and other factors, the Company plans for specific capital tive to demand. An extended period of supply/demand imbalance improvements on an annual basis. Certain of these improvements could negatively impact market rate levels for all transportation help ensure facilities, such as fuelling stations and waste water services, and more specifically the Company’s ability to maintain or and storm water treatment systems, comply with environmental increase rates. This, in turn, could materially and adversely affect the standards and include new construction and the updating of Company’s business, results of operations or financial position. 44 CN | 2015 Annual Report Management’s Discussion and Analysis The level of consolidation of rail systems in the U.S. has resulted The environmental liability for any given contaminated site in larger rail systems that are in a position to compete effectively varies depending on the nature and extent of the contamination; with the Company in numerous markets. the available clean-up techniques; evolving regulatory standards There can be no assurance that the Company will be able to governing environmental liability; and the number of potentially compete effectively against current and future competitors in responsible parties and their financial viability. As such, the ultimate the transportation industry, and that further consolidation within cost of addressing known contaminated sites cannot be definitively the transportation industry and that legislation allowing for more established. Also, additional contaminated sites yet unknown may leniency in size and weight for motor carriers will not adversely be discovered or future operations may result in accidental releases. affect the Company’s competitive position. No assurance can be While some exposures may be reduced by the Company’s risk given that competitive pressures will not lead to reduced revenues, mitigation strategies (including periodic audits, employee training profit margins or both. Environmental matters programs, emergency plans and procedures, and insurance), many en- vironmental risks are driven by external factors beyond the Company’s control or are of a nature which cannot be completely eliminated. The Company’s operations are subject to numerous federal, provin- Therefore, there can be no assurance, notwithstanding the Company’s cial, state, municipal and local environmental laws and regulations mitigation strategies, that liabilities or costs related to environmental in Canada and the U.S. concerning, among other things, emissions matters will not be incurred in the future or that environmental mat- into the air; discharges into waters; the generation, handling, ters will not have a material adverse effect on the Company’s results storage, transportation, treatment and disposal of waste, hazardous of operations, financial position or liquidity, or reputation. substances and other materials; decommissioning of underground and aboveground storage tanks; and soil and groundwater contam- Personal injury and other claims ination. A risk of environmental liability is inherent in railroad and In the normal course of business, the Company becomes involved in related transportation operations; real estate ownership, operation various legal actions seeking compensatory and occasionally punitive or control; and other commercial activities of the Company with re- damages, including actions brought on behalf of various purported spect to both current and past operations. As a result, the Company classes of claimants and claims relating to employee and third-party incurs significant operating and capital costs, on an ongoing basis, personal injuries, occupational disease, and property damage, arising associated with environmental regulatory compliance and clean-up out of harm to individuals or property allegedly caused by, but not lim- requirements in its railroad operations and relating to its past and ited to, derailments or other accidents. The Company maintains pro- present ownership, operation or control of real property. visions for such items, which it considers to be adequate for all of its While the Company believes that it has identified the costs likely outstanding or pending claims and benefits from insurance coverage to be incurred for environmental matters in the next several years for occurrences in excess of certain amounts. The final outcome with based on known information, the discovery of new facts, future respect to actions outstanding or pending at December 31, 2015, changes in laws, the possibility of releases of hazardous materials or with respect to future claims, cannot be predicted with certainty, into the environment and the Company’s ongoing efforts to identify and therefore there can be no assurance that their resolution will not potential environmental liabilities that may be associated with its have a material adverse effect on the Company’s results of operations, properties may result in the identification of additional environ- financial position or liquidity, in a particular quarter or fiscal year. mental liabilities and related costs. In railroad and related transportation operations, it is possible Labor negotiations that derailments or other accidents, including spills and releases of As at December 31, 2015, CN employed a total of 16,022 employees hazardous materials, may occur that could cause harm to human in Canada, of which 11,708, or 73%, were unionized employees. health or to the environment. In addition, the Company is also As at December 31, 2015, CN employed a total of 7,150 employees exposed to potential catastrophic liability risk, faced by the railroad in the U.S., of which 5,584, or 78%, were unionized employees. industry generally, in connection with the transportation of toxic in- The Company’s relationships with its unionized workforce are halation hazard materials such as chlorine and anhydrous ammonia, governed by, amongst other items, collective agreements which are or other dangerous commodities like crude oil and propane that the negotiated from time to time. Disputes relating to the renewal of Company may be required to transport as a result of its common collective agreements could potentially result in strikes, slowdowns carrier obligations. Therefore, the Company may incur costs in and loss of business. Future labor agreements or renegotiated the future, which may be material, to address any such harm, agreements could increase labor and fringe benefits expenses. compliance with laws or other risks, including costs relating to the There can be no assurance that the Company will be able to renew performance of clean-ups, payment of environmental penalties and and have its collective agreements ratified without any strikes or remediation obligations, and damages relating to harm to individ- lockouts or that the resolution of these collective bargaining nego- uals or property. tiations will not have a material adverse effect on the Company’s results of operations or financial position. CN | 2015 Annual Report 45 Management’s Discussion and Analysis Canadian workforce Regulation During 2015, the Company renewed collective agreements with Economic regulation – Canada the United Steelworkers of America (USW) governing maintenance The Company’s rail operations in Canada are subject to economic of way employees; the Teamsters Canada Rail Conference (TCRC) regulation by the Canadian Transportation Agency (“Agency”) governing rail traffic controllers and locomotive engineers; Unifor, under the Canada Transportation Act (CTA). The CTA provides rate governing clerical, intermodal and shopcraft employees, as well and service remedies, including final offer arbitration (FOA), com- as owner-operator truck drivers. The new collective agreements petitive line rates and compulsory interswitching. It also regulates will expire at various dates between December 31, 2017 and the maximum revenue entitlement for the movement of grain, March 31, 2019. U.S. workforce charges for railway ancillary services and noise-related disputes. In addition, various Company business transactions must gain prior regulatory approval, with attendant risks and uncertainties. As of February 1, 2016, the Company had in place agreements On May 29, 2014, Bill C-30 came into force, which provides with bargaining units representing the entire unionized workforce authority to the Government to establish minimum volumes of at Grand Trunk Western Railroad Company (GTW), companies grain to be moved and penalties in the event that thresholds are owned by Illinois Central Corporation (ICC), companies owned not met. During 2014, the Government of Canada issued Orders by Wisconsin Central Ltd. (WC), Bessemer & Lake Erie Railroad in Council prescribing each of the Company and Canadian Pacific Company (BLE) and The Pittsburgh and Conneaut Dock Company Railway Company to move various weekly minimum volumes of (PCD). Agreements in place have various moratorium provisions grain during specified periods through to March 28, 2015. Since up to 2018, which preserve the status quo in respect of the given March 28, 2015, the Government has not imposed any minimum collective agreement during the terms of such moratoriums. All grain volume requirements; however, as long as the amendments in collective agreements covering non-operating craft employees and Bill C-30 remain in effect, the Government can choose to stipulate four collective agreements covering operating craft employees are volume requirements. Under other provisions of this bill, the Agency currently under renegotiation. also extended the interswitching distance to 160 kilometers from During 2015, the Company renewed a collective agreement with the previous 30 kilometers limits for all commodities in the prov- the United Transportation Union (UTU) (a division of the International inces of Manitoba, Saskatchewan and Alberta; and issued regula- Association of Sheet Metal, Air, Rail, and Transportation Workers - tions defining what constitutes ‘operational terms’ for the purpose SMART) governing conductors on the Grand Trunk Western. On of rail level of service arbitrations. In the event that a railway fails to January 15, 2016, the Company renewed three additional collective fulfill its service level obligations, Bill C-30 also allows the Agency agreements with UTU governing 57 yardmasters at GTW, WC and a to order a railway company to pay shippers for expenses incurred. small subset working on the ICC. The general approach to labor negotiations by U.S. Class I rail- roads is to bargain on a collective national basis with the industry, The amendments introduced by Bill C-30 are intended to remain in effect up to August 1, 2016, unless further extended by Parliament. On June 25, 2014, the Government launched a statutory review which GTW, ICC, WC and BLE have agreed to participate in, effect- of the CTA. The panel appointed by the Government to conduct ive January 2015, for collective agreements covering non-operating this review was expected to provide their report to the Federal employees. Collective agreements covering operating employees Minister of Transport on December 24, 2015. CN provided com- at GTW, ICC, WC, BLE and all employees at PCD continue to be ments on the subjects being examined in 2015. It is unclear what bargained on a local (corporate) basis. actions, if any, will be taken by Transport Canada after they consider Where negotiations are ongoing, the terms and conditions of the findings of the report; however, additional regulations could be existing agreements generally continue to apply until new agree- proposed as a result of the review. ments are reached or the processes of the Railway Labor Act have On June 18, 2015, Bill C-52 came into force, which requires been exhausted. 46 CN | 2015 Annual Report railway companies to maintain minimum liability insurance coverage and establishes a strict liability regime on railway companies up to their minimum insurance levels in respect of losses incurred as a result of a railway accident involving crude oil. Bill C-52 creates a fund capitalized through levies payable by crude oil shippers to compensate for losses exceeding the railway company’s minimum insurance level. Currently, the Company’s liability insurance coverage exceeds the minimum required. The provisions relating to insurance requirements and the fund are expected to come into force in June 2016. Management’s Discussion and Analysis No assurance can be given that these and any other current or Pursuant to the Passenger Rail Investment and Improvement Act future regulatory or legislative initiatives by the Canadian federal of 2008 (PRIIA), the U.S. Congress authorized the STB to investigate government and agencies will not materially adversely affect the any railroad over whose track Amtrak operates that fails to meet Company’s results of operations or its competitive and financial heightened performance standards jointly promulgated by the position. Economic regulation – U.S. Federal Railroad Administration (FRA) and Amtrak for Amtrak oper- ations extending over two calendar quarters and to determine the cause of such failures. Should the STB commence an investigation The Company’s U.S. rail operations are subject to economic and determine that a failure to meet these standards is due to the regulation by the Surface Transportation Board (STB). The STB host railroad’s failure to provide preference to Amtrak, the STB is serves as both an adjudicatory and regulatory body and has authorized to assess damages against the host railroad. On January jurisdiction over railroad rate and service issues and rail restructuring 19, 2012, Amtrak filed a complaint with the STB to commence such transactions such as mergers, line sales, line construction and line an investigation, including a request for damages for preference abandonments. As such, various Company business transactions failures, for allegedly sub-standard performance of Amtrak trains on must gain prior regulatory approval and aspects of its pricing and CN’s ICC and GTW lines. On December 19, 2014, the STB granted service practices may be subject to challenge, with attendant risks Amtrak’s motion to amend its complaint to limit the STB’s investi- and uncertainties. The STB has undertaken proceedings in the past gation to a single Amtrak service on CN’s ICC line. That case has few years in a number of significant matters that remain pending, been stayed pending a notice of proposed rulemaking on December as noted below. 28, 2015 to define on-time performance under Section 213 of On December 12, 2013, the STB instituted a proceeding on PRIIA, and a proposed policy statement on the same date offering how to ensure its rate complaint procedures are accessible to grain guidance on appropriate evidence and on preference issues in such shippers and provide effective protection against unreasonable grain investigations. During this period, the rail industry also challenged rates, subsequent to which it received comments and replies. The as unconstitutional Congress’ delegation to Amtrak and the FRA STB held a hearing on these matters in 2015. No further significant of joint legislative authority to promulgate the PRIIA performance developments have occurred. standards, and on July 2, 2013, the U.S. Court of Appeals for the On December 20, 2013, the STB instituted a rulemaking to District of Columbia Circuit so ruled. On March 9, 2015, however, review how it determines the rail industry’s cost of equity capital, the Supreme Court vacated the D.C. Circuit’s July 2, 2013 decision and on April 2, 2014, joined it with a proceeding to explore its and returned the case to that court for review of the constitutional methodology for determining railroad revenue adequacy and the claims not previously ruled upon. As a result, the joint FRA/Amtrak revenue adequacy component used in judging the reasonableness performance standards became applicable again on April 10, 2015, of rail rates. The STB held hearings on these matters on July 22-23, pending the D.C. Circuit’s review. The court held oral argument 2015. In addition, on September 8, 2015, the STB made its annual revenue adequacy determination for Class I carriers for 2014. The STB determined that four Class I carriers are revenue adequate, among them Grand Trunk Corporation, which includes CN’s U.S. affiliated operations. On October 8, 2014, the STB issued a decision requiring all Class I railroads to provide each week a broad range of operational data, starting October 22, 2014. The STB is seeking to provide on November 10, 2015, and a decision is expected during the first quarter of 2016. The U.S. Congress has had under consideration various pieces of legislation that would increase federal economic regulation of the railroad industry. On March 24, 2015, legislation was introduced in the Senate (S.853) which would (among a number of other provi- sions) allow for reciprocal switching for junctions within 100 miles, however, no further action was taken in Congress as of the date access to rail performance data sought by shippers and to meet of this MD&A. On December 18, 2015, STB reauthorization the STB’s objective of promoting transparency, accountability, and legislation (S.808) was passed by Congress and signed into law by improvements in rail service. The STB also directed that data specific the President. In addition to addressing arbitration and the Board’s to Chicago and a narrative summary of operating conditions in investigatory authority, the new law further streamlines the STB’s Chicago as well as Chicago Transportation Coordination Office rate-case review process, and extends current STB membership from (CTCO) contingency protocols and other industry-wide information three Commissioners to five. be provided from individual railroads. On December 30, 2014, the STB issued a notice of proposed rulemaking to require Class I railroads to permanently report certain service performance metrics The acquisition of the Elgin, Joliet and Eastern Railway Company (EJ&E) in 2009 followed an extensive regulatory approval process by the STB, which included an Environmental Impact Statement on a weekly basis, however no final rule has been issued. (EIS) that resulted in conditions imposed to mitigate municipalities’ CN | 2015 Annual Report 47 Management’s Discussion and Analysis concerns regarding increased rail activity expected along the EJ&E Safety regulation – Canada line. The Company accepted the STB-imposed conditions with The Company’s rail operations in Canada are subject to safety one exception. The Company filed an appeal at the U.S. Court of regulation by the Federal Minister of Transport under the Railway Appeals for the D.C. Circuit challenging the STB’s condition requir- Safety Act as well as the rail portions of other safety-related ing the installation of grade separations at two locations along the statutes, which are admistered by Transport Canada. The Company EJ&E line at Company funding levels significantly beyond prior STB may be required to transport toxic inhalation hazard materials as practice. Appeals were also filed by certain communities challenging a result of its common carrier obligations and, as such, is exposed the sufficiency of the EIS. On March 15, 2011, the Court denied to additional regulatory oversight in Canada. The Transportation the CN and community appeals. As such, the Company has of Dangerous Goods Act, also administered by Transport Canada, estimated remaining commitments, through to December 31, 2017, establishes the safety requirements for the transportation of goods of approximately $48 million (US$35 million), in relation to the classified as dangerous and enables the establishment of regulations acquisition. for security training and screening of personnel working with dan- The STB also imposed a five-year monitoring and oversight con- gerous goods, as well as the development of a program to require dition on the transaction, subsequently extended by an additional a transportation security clearance for dangerous goods and that year to January 2015, and an additional two years to January 23, dangerous goods be tracked during transport. 2017, during which the Company is required to file with the STB Following a significant derailment involving a non-related monthly operational reports as well as quarterly reports on the im- short-line railroad within the Province of Quebec (“Lac-Mégantic plementation status of the STB-imposed mitigation conditions. This derailment”) on July 6, 2013, several measures have been taken by permits the STB to take further action if there is a material change Transport Canada to strengthen the safety of the railway and trans- in the facts and circumstances upon which it relied in imposing the portation of dangerous goods systems in Canada. Amendments to specific mitigation conditions. the Canada Railway Safety Act and Transportation of Dangerous On November 8, 2012, the STB denied a request made by Goods Act include requirements for classification and sampling the Village of Barrington, Illinois (Barrington) to reopen its EJ&E of crude oil, the provision of yearly aggregate information on the approval decision and impose additional mitigation requiring CN nature and volume of dangerous goods the company transports to provide a grade separation at a location along the EJ&E line in by rail through designated municipalities, and new speed limit re- Barrington, a requested condition the STB had previously denied. strictions of 40 miles per hour for certain trains carrying dangerous On July 18, 2014, the U.S. Court of Appeals for the D.C. Circuit commodities. Additional requirements for railway companies to denied Barrington’s appeal of the STB’s decision. On November conduct route assessments for rail corridors handling significant 26, 2014, Barrington again sought reopening to have a grade volumes of dangerous goods and an Emergency Response separation condition imposed at CN’s expense at the intersection of Assistance Plan in order to ship large volumes of flammable liquids U.S. Highway 14 and the EJ&E line in Barrington at CN’s expense. were also put into place. Further to this, Transport Canada issued Barrington’s petition to reopen was denied on May 15, 2015, and new rules prohibiting the use of certain DOT-111 tank cars for its petition for reconsideration of that decision was denied on the transportation of dangerous goods, and announced a new November 4, 2015. standard for tank cars transporting flammable liquid dangerous The resolution of matters that could arise during the STB’s goods. The new standard, called TC-117, establishes enhanced remaining oversight of the transaction cannot be predicted with construction specifications along with a phase out schedule for certainty, and therefore, there can be no assurance that their DOT-111 and CPC-1232 tank cars. resolution will not have a material adverse effect on the Company’s Transport Canada has also issued new regulations that provide financial position or results of operations. for: (1) administrative monetary penalties that could be issued for violation of the Railway Safety Act and its associated regulations, No assurance can be given that these and any other current or (2) specific standards for new highway-railway crossings and future regulatory or legislative initiatives by the U.S. federal govern- requirements that existing crossings be upgraded to basic safety ment and agencies will not materially adversely affect the Company’s standards within seven years, as well as safety related data that results of operations or its competitive and financial position. must be provided by railway companies on an annual basis, and (3) modified requirements for safety management systems for both federally-regulated railway companies as well as local carriers operating on railway lines of federally-regulated carriers. As well, under Bill C-52, which was enacted on June 18, 2015, the Agency now has jurisdiction to order railway companies to compensate municipalities for the costs incurred in responding to fires caused by railway operations. 48 CN | 2015 Annual Report Management’s Discussion and Analysis In compliance with an order issued by Transport Canada, the As a result of FRA’s Emergency Order No. 28, the Railroad Safety Railway Association of Canada filed revised rules on behalf of CN Advisory Committee (RSAC), which was established by the FRA and its other member railway companies, respecting the secure- in 1996 to provide advice and recommendations to the FRA on ment of unattended locomotives and crew size requirements, which railroad safety matters, was directed with four new tasks: (1) train were approved by the Federal Minister of Transport. Additional crew size, (2) operational testing for securement, (3) securement rules are under development. CN has reviewed its safety policies for and (4) hazardous material issues. CN was an active participant in all unattended trains and adjusted its safety practices in light of events four task groups, which have all now completed their work. occurring subsequent to the Lac-Mégantic derailment. The National Transportation Safety Board (NTSB) issued a series No assurance can be given that these and any other current or future address the safety risk of transporting crude oil by rail. Specifically, regulatory or legislative initiatives by the Canadian federal govern- the NTSB recommended: (1) expanded hazardous materials route ment and agencies will not materially adversely affect the Company’s planning for railroads to avoid populated and other sensitive areas; results of operations or its competitive and financial position. (2) development of an FRA/PHMSA audit program to ensure that of recommendations to the U.S. Department of Transportation, to Safety regulation – U.S. railroads carrying petroleum products have adequate emergency response capabilities to address worst-case discharges of the The Company’s U.S. rail operations are subject to safety regulation product; and (3) audits of shippers and railroads to ensure that they by the FRA under the Federal Railroad Safety Act as well as rail are properly classifying hazardous materials being transported and portions of other safety statutes, with the transportation of certain that they have adequate safety and security plans in place. hazardous commodities also governed by regulations promulgated The PHMSA issued a final rule on May 8, 2015, in coordination by the Pipeline and Hazardous Materials Safety Administration with the FRA, containing new requirements for tank cars moving in (PHMSA). The PHMSA requires carriers operating in the U.S. to re- high-hazard flammable trains (HHFTs) and related speed restrictions, port annually the volume and route-specific data for cars containing as well as other requirements, including the use of electronically these commodities; conduct a safety and security risk analysis for controlled pneumatic (ECP) brakes. To be used in an HHFT, new each used route; identify a commercially practicable alternative tank cars constructed after October 1, 2015 will have to meet route for each used route; and select for use the practical route pos- enhanced DOT-117 design or performance criteria, while existing ing the least safety and security risk. In addition, the Transportation tank cars will have to be retrofitted based on a DOT-prescribed Security Administration (TSA) requires rail carriers to provide upon schedule. On June 12, 2015, the AAR filed an administrative appeal request, within five minutes for a single car and 30 minutes for with PHMSA challenging, among other matters, the agency’s multiple cars, location and shipping information on cars on their requirement for railroads to install ECP brakes on certain HHFTs. networks containing toxic inhalation hazard materials and certain On November 6, 2015, PHMSA denied AAR’s administrative appeal. radioactive or explosive materials; and ensure the secure, attended However, as part of the surface transportation reauthorization bill transfer of all such cars to and from shippers, receivers and other known as the FAST Act, which was enacted on December 4, 2015, carriers that will move from, to, or through designated high-threat Congress substituted certain modified requirements supported by urban areas. the industry, and also provided for re-visitation of the ECP brake In the aftermath of the July 2013 Lac-Mégantic derailment, requirement through an 18-month independent study of the costs, the FRA issued Emergency Order No. 28, Notice No. 1 on August 2, benefits and operational impacts of ECP brakes to be conducted by 2013 directing that railroads take specific actions regarding the Government Accountability Office, in addition to further testing. unattended trains transporting specified hazardous materials, Rail safety bills have been introduced in the U.S. Congress including securement of these trains. That same day, the FRA and following the Lac-Mégantic derailment, however these bills have the PHMSA issued Safety Advisory 2013-06, which made recom- not advanced due to the fact that much of the substance of rail mendations to railroads on issues including crew staffing practices safety was addressed under the recently enacted FAST Act, and by and operational testing to ensure employees’ compliance with FRA and PHMSA regulatory measures. securement-related rules, as well as recommendations to shippers of crude oil to be transported by rail. In addition, the railroad No assurance can be given that these and any other current or industry has acted on its own to enhance rail safety in light of the future regulatory or legislative initiatives by the U.S. federal govern- Lac-Mégantic derailment and fire. Effective August 5, 2013, the ment and agencies will not materially adversely affect the Company’s Association of American Railroads (AAR) amended the industry’s results of operations or its competitive and financial position. Recommended Railroad Operating Practices for Transportation of Hazardous Materials by expanding the definition of a “key train” (for which heightened operating safeguards are required). CN | 2015 Annual Report 49 Management’s Discussion and Analysis Positive Train Control On October 16, 2008, the U.S. Congress enacted the Rail Safety Improvement Act of 2008, which required all Class I railroads and intercity passenger and commuter railroads to implement a PTC • Regulations imposed by the CBP requiring advance notification by all modes of transportation for all shipments into the U.S. The CBSA is also working on similar requirements for Canada-bound traffic. system by December 31, 2015 on mainline track where intercity • Inspection for imported fruits and vegetables grown in Canada passenger railroads and commuter railroads operate and where and the agricultural quarantine and inspection (AQI) user fee for toxic inhalation hazard materials are transported. PTC is a collision all traffic entering the U.S. from Canada. avoidance technology intended to override locomotive controls and • Gamma ray screening of cargo entering the U.S. from Canada, stop a train before an accident. Pursuant to the Positive Train Control and potential security and agricultural inspections at the Enforcement and Implementation Act of 2015 and the FAST Act of Canada/U.S. border. 2015 (collectively the “PTCEIA”), Congress extended the PTC dead- line until December 31, 2018, with the option for a railroad carrier The Company has worked with the AAR to develop and put in place to implement PTC by no later than December 31, 2020. Pursuant to an extensive industry-wide security plan to address terrorism and sec- the PTCEIA, the Company submitted its revised implementation plan urity-driven efforts by state and local governments seeking to restrict on January 27, 2016. The Company will also have to file a progress the routings of certain hazardous materials. If such state and local report on March 31, 2016, and annually thereafter until implementa- routing restrictions were to go into force, they would be likely to tion is completed. The Company was progressing its implementation add to security concerns by foreclosing the Company’s most optimal of PTC pursuant to the prior law and will continue to do so under the new timeline, including working with the FRA and other Class I railroads to satisfy the requirements for U.S. network interoperability. and secure transportation routes, leading to increased yard handling, longer hauls, and the transfer of traffic to lines less suitable for moving hazardous materials, while also infringing upon the exclusive In connection with CN’s revised PTC implementation plan, CN and uniform federal oversight over railroad security matters. performed a reassessment of all costs associated with its implemen- tation plan and now estimates that the total implementation cost While the Company will continue to work closely with the CBSA, will be US$1.2 billion, of which US$0.2 billion has been spent as CBP, and other Canadian and U.S. agencies, as described above, of December 31, 2015. The revised estimated total costs take into no assurance can be given that these and future decisions by the consideration the added complexities identified during the detailed U.S., Canadian, provincial, state, or local governments on homeland review as well as technical challenges anticipated to comply with the security matters, legislation on security matters enacted by the regulations and to ensure the interoperability with other railroads U.S. Congress or Parliament, or joint decisions by the industry in and to maintain optimal operating performance. response to threats to the North American rail network, will not Security materially adversely affect the Company’s results of operations, or its competitive and financial position. The Company is subject to statutory and regulatory directives in the U.S. addressing homeland security concerns. In the U.S., Vessels safety matters related to security are overseen by the TSA, which The Company’s vessel operations are subject to regulation by the is part of the U.S. Department of Homeland Security (DHS) and U.S. Coast Guard (USCG) and the Department of Transportation, the PHMSA, which, like the FRA, is part of the U.S. Department of Maritime Administration, which regulate the ownership and oper- Transportation. Border security falls under the jurisdiction of U.S. ation of vessels operating on the Great Lakes and in U.S. coastal Customs and Border Protection (CBP), which is part of the DHS. waters. In addition, the Environmental Protection Agency (EPA) has In Canada, the Company is subject to regulation by the Canada authority to regulate air emissions from these vessels. Border Services Agency (CBSA). Matters related to agriculture-related The Federal Maritime Commission, which has authority over shipments crossing the Canada/U.S. border also fall under the oceanborne transport of cargo into and out of the U.S., initiated jurisdiction of the U.S. Department of Agriculture (USDA) and the a Notice of Inquiry in 2011 to examine whether the U.S. Harbor Food and Drug Administration (FDA) in the U.S. and the Canadian Maintenance Tax (HMT) and other factors may be contributing Food Inspection Agency (CFIA) in Canada. More specifically, the to the diversion of U.S.-bound cargo to Canadian and Mexican Company is subject to: seaports, which could affect CN rail operations. While legislative • Border security arrangements, pursuant to an agreement the initiatives have been launched since then, no further action was Company and Canadian Pacific Railway Company entered into taken in the Senate or the House of Representatives as of the date with the CBP and the CBSA. of this MD&A. • The CBP’s Customs-Trade Partnership Against Terrorism (C-TPAT) program and designation as a low-risk carrier under CBSA’s Customs Self-Assessment (CSA) program. 50 CN | 2015 Annual Report Management’s Discussion and Analysis Transportation of hazardous materials Reliance on technology As a result of its common carrier obligations, the Company is legally The Company relies on information technology in all aspects of its required to transport toxic inhalation hazard materials regardless business. While the Company has business continuity and disaster of risk or potential exposure or loss. A train accident involving the recovery plans, as well as other mitigation programs in place, a transport of these commodities could result in significant costs and cyber security attack and significant disruption or failure of its claims for personal injury, property damage, and environmental information technology and communications systems could result penalties and remediation in excess of insurance coverage for these in service interruptions, safety failures, security violations, regulatory risks, which may materially adversely affect the Company’s results of compliance failures or other operational difficulties and compromise operations, or its competitive and financial position. corporate information and assets against intruders and, as such, Economic conditions could adversely affect the Company’s results of operations, financial position or liquidity. If the Company is unable to acquire or imple- The Company, like other railroads, is susceptible to changes in the ment new technology, it may suffer a competitive disadvantage, economic conditions of the industries and geographic areas that which could also have an adverse effect on the Company’s results produce and consume the freight it transports or the supplies it of operations, financial position or liquidity. requires to operate. In addition, many of the goods and commod- ities carried by the Company experience cyclicality in demand. Trade restrictions For example, the current volatility in domestic and global energy Global as well as North American trade conditions, including markets could impact the demand for transportation services as well trade barriers on certain commodities, may interfere with the free as impact the Company’s fuel costs and surcharges. In addition, the circulation of goods across Canada and the U.S. current volatility in other commodity markets such as coal and iron ore could have an impact on volumes. Many of the bulk commod- Terrorism and international conflicts ities the Company transports move offshore and are affected more Potential terrorist actions can have a direct or indirect impact on by global rather than North American economic conditions. Adverse the transportation infrastructure, including railway infrastructure North American and global economic conditions, or economic or in North America, and can interfere with the free flow of goods. industrial restructuring, that affect the producers and consumers Rail lines, facilities and equipment could be directly targeted or of the commodities carried by the Company, including customer become indirect casualties, which could interfere with the free flow insolvency, may have a material adverse effect on the volume of of goods. International conflicts can also have an impact on the rail shipments and/or revenues from commodities carried by the Company’s markets. Government response to such events could ad- Company, and thus materially and negatively affect its results of versely affect the Company’s operations. Insurance premiums could operations, financial position, or liquidity. also increase significantly or coverage could become unavailable. Pension funding volatility Customer credit risk The Company’s funding requirements for its defined benefit pension In the normal course of business, the Company monitors the finan- plans are determined using actuarial valuations. See the section of cial condition and credit limits of its customers and reviews the credit this MD&A entitled Critical accounting estimates – Pensions and history of each new customer. Although the Company believes there other postretirement benefits for information relating to the funding are no significant concentrations of credit risk, economic conditions of the Company’s defined benefit pension plans. Adverse changes can affect the Company’s customers and can result in an increase with respect to pension plan returns and the level of interest rates to the Company’s credit risk and exposure to the business failures from the date of the last actuarial valuations as well as changes to of its customers. A widespread deterioration of customer credit and existing federal pension legislation may significantly impact future business failures of customers could have a material adverse effect pension contributions and have a material adverse effect on the on the Company’s results of operations, financial position or liquidity. funding status of the plans and the Company’s results of operations. There can be no assurance that the Company’s pension expense and Liquidity funding of its defined benefit pension plans will not increase in the Disruptions in the financial markets or deterioration of the future and thereby negatively impact earnings and/or cash flow. Company’s credit ratings could hinder the Company’s access to external sources of funding to meet its liquidity needs. There can be no assurance that changes in the financial markets will not have a negative effect on the Company’s liquidity and its access to capital at acceptable rates. CN | 2015 Annual Report 51 Management’s Discussion and Analysis Supplier concentration Fuel costs The Company operates in a capital-intensive industry where The Company, like other railroads, is susceptible to the volatility of the complexity of rail equipment limits the number of suppliers fuel prices due to changes in the economy or supply disruptions. Fuel available. The supply market could be disrupted if changes in the shortages can occur due to refinery disruptions, production quota economy caused any of the Company’s suppliers to cease produc- restrictions, climate, and labor and political instability. Increases in tion or to experience capacity or supply shortages. This could also fuel prices or supply disruptions may materially adversely affect the result in cost increases to the Company and difficulty in obtaining Company’s results of operations, financial position or liquidity. and maintaining the Company’s rail equipment and materials. Since the Company also has foreign suppliers, international relations, Foreign exchange trade restrictions and global economic and other conditions may The Company conducts its business in both Canada and the U.S. potentially interfere with the Company’s ability to procure necessary and as a result, is affected by currency fluctuations. Changes in the equipment. Widespread business failures of, or restrictions on exchange rate between the Canadian dollar and other currencies suppliers, could have a material adverse effect on the Company’s (including the US dollar) make the goods transported by the results of operations or financial position. Company more or less competitive in the world marketplace and thereby may adversely affect the Company’s revenues and expenses. Availability of qualified personnel The Company, like other companies in North America, may experi- Interest rate ence demographic challenges in the employment levels of its work- The Company is exposed to interest rate risk relating to the force. Changes in employee demographics, training requirements Company’s long-term debt. The Company mainly issues fixed-rate and the availability of qualified personnel, particularly locomotive debt, which exposes the Company to variability in the fair value engineers and trainmen, could negatively impact the Company’s of the debt. The Company also issues debt with variable interest ability to meet demand for rail service. The Company expects that rates, which exposes the Company to variability in interest expense. approximately 30% of its workforce will be eligible to retire or leave Adverse changes to market interest rates may significantly impact the through normal attrition (death, termination, resignation) within the fair value or future cash flows of the Company’s financial instru- next five-year period. The Company monitors employment levels ments. There can be no assurance that changes in the market interest and seeks to ensure that there is an adequate supply of personnel rates will not have a negative effect on the Company’s liquidity. to meet rail service requirements. However, the Company’s efforts to attract and retain qualified personnel may be hindered by specific Transportation network disruptions conditions in the job market. No assurance can be given that Due to the integrated nature of the North American freight demographic or other challenges will not materially adversely affect transportation infrastructure, the Company’s operations may be the Company’s results of operations or its financial position. negatively affected by service disruptions of other transportation links such as ports and other railroads which interchange with the Company. A significant prolonged service disruption of one or more of these entities could have an adverse effect on the Company’s results of operations, financial position or liquidity. Furthermore, deterioration in the cooperative relationships with the Company’s connecting carriers could directly affect the Company’s operations. 52 CN | 2015 Annual Report Management’s Discussion and Analysis Weather and climate change Controls and procedures The Company’s success is dependent on its ability to operate its railroad efficiently. Severe weather and natural disasters, such as extreme cold or heat, flooding, drought, hurricanes and earth- The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s quakes, can disrupt operations and service for the railroad, affect disclosure controls and procedures (as defined in Exchange Act the performance of locomotives and rolling stock, as well as disrupt Rules 13a-15(e) and 15d-15(e)) as of December 31, 2015, have operations for both the Company and its customers. Climate concluded that the Company’s disclosure controls and procedures change, including the impact of global warming, has the potential were effective. physical risk of increasing the frequency of adverse weather events, which can disrupt the Company’s operations, damage its infrastructure or properties, or otherwise have a material adverse effect on the Company’s results of operations, financial position or liquidity. In addition, although the Company believes that the During the fourth quarter ended December 31, 2015, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. As of December 31, 2015, management has assessed the growing support for climate change legislation is likely to result in effectiveness of the Company’s internal control over financial re- changes to the regulatory framework in Canada and the U.S., it is porting using the criteria set forth by the Committee of Sponsoring too early to predict the manner or degree of such impact on the Company at this time. Restrictions, caps, taxes, or other controls Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework (2013). Based on this assessment, on emissions of greenhouse gasses, including diesel exhaust, could management has determined that the Company’s internal control significantly increase the Company’s capital and operating costs or over financial reporting was effective as of December 31, 2015, affect the markets for, or the volume of, the goods the Company and issued Management’s Report on Internal Control over Financial carries thereby resulting in a material adverse effect on operations, Reporting dated February 1, 2016 to that effect. financial position, results of operations or liquidity. Climate change legislation and regulation could affect CN’s customers; make it difficult for CN’s customers to produce products in a cost-competitive manner due to increased energy costs; and increase legal costs related to defending and resolving legal claims and other litigation related to climate change. CN | 2015 Annual Report 53 Management’s Discussion and Analysis Consolidated Financial Statements Management’s Report on Internal Control Report of Independent Registered Public Accounting Firm over Financial Reporting Management is responsible for establishing and maintaining To the Shareholders and Board of Directors of the Canadian adequate internal control over financial reporting. Internal control National Railway Company over financial reporting is a process designed to provide reason- We have audited the accompanying consolidated balance sheets able assurance regarding the reliability of financial reporting and of the Canadian National Railway Company (the “Company”) as the preparation of financial statements for external purposes in of December 31, 2015 and 2014, and the related consolidated accordance with generally accepted accounting principles. Because statements of income, comprehensive income, changes in share- of its inherent limitations, internal control over financial reporting holders’ equity and cash flows for each of the years in the three- may not prevent or detect misstatements. year period ended December 31, 2015. These consolidated financial Management has assessed the effectiveness of the Company’s statements are the responsibility of the Company’s management. internal control over financial reporting as of December 31, Our responsibility is to express an opinion on these consolidated 2015 using the criteria set forth by the Committee of Sponsoring financial statements based on our audits. Organizations of the Treadway Commission (COSO) in Internal We conducted our audits in accordance with Canadian generally Control - Integrated Framework (2013). Based on this assessment, accepted auditing standards and the standards of the Public management has determined that the Company’s internal control Company Accounting Oversight Board (United States). Those over financial reporting was effective as of December 31, 2015. standards require that we plan and perform the audit to obtain rea- KPMG LLP, an independent registered public accounting sonable assurance about whether the financial statements are free firm, has issued an unqualified audit report on the effectiveness of material misstatement. An audit includes examining, on a test of the Company’s internal control over financial reporting as of basis, evidence supporting the amounts and disclosures in the finan- December 31, 2015 and has also expressed an unqualified audit cial statements. An audit also includes assessing the accounting opinion on the Company’s 2015 consolidated financial statements principles used and significant estimates made by management, as as stated in their Reports of Independent Registered Public well as evaluating the overall financial statement presentation. We Accounting Firm dated February 1, 2016. believe that our audits provide a reasonable basis for our opinion. Claude Mongeau President and Chief Executive Officer February 1, 2016 In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2015 and 2014, and its consolidated results of operations and its consolidated cash flows for each of the years in the three-year period ended December 31, 2015, in conformity with United States generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2015, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and our report dated February 1, 2016 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. Luc Jobin Executive Vice-President and Chief Financial Officer February 1, 2016 KPMG LLP* Montreal, Canada February 1, 2016 * FCPA auditor, FCA, public accountancy permit No. A106087 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. KPMG Canada provides services to KPMG LLP. 54 CN | 2015 Annual Report Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of the Canadian the maintenance of records that, in reasonable detail, accurately National Railway Company and fairly reflect the transactions and dispositions of the assets of We have audited the Canadian National Railway Company’s the company; (2) provide reasonable assurance that transactions are (the “Company”) internal control over financial reporting as of recorded as necessary to permit preparation of financial statements December 31, 2015, based on criteria established in Internal Control - in accordance with generally accepted accounting principles, and Integrated Framework (2013) issued by the Committee of Sponsoring that receipts and expenditures of the company are being made only Organizations of the Treadway Commission (“COSO”). The Company’s in accordance with authorizations of management and directors management is responsible for maintaining effective internal control of the company; and (3) provide reasonable assurance regarding over financial reporting, and for its assessment of the effectiveness of prevention or timely detection of unauthorized acquisition, use, or internal control over financial reporting included in the accompanying disposition of the company’s assets that could have a material effect Management’s Report on Internal Control over Financial Reporting. Our on the financial statements. responsibility is to express an opinion on the Company’s internal control Because of its inherent limitations, internal control over over financial reporting based on our audit. financial reporting may not prevent or detect misstatements. Also, We conducted our audit in accordance with the standards of the projections of any evaluation of effectiveness to future periods are Public Company Accounting Oversight Board (United States). Those subject to the risk that controls may become inadequate because standards require that we plan and perform the audit to obtain of changes in conditions, or that the degree of compliance with the reasonable assurance about whether effective internal control over policies or procedures may deteriorate. financial reporting was maintained in all material respects. Our audit In our opinion, the Company maintained, in all material respects, included obtaining an understanding of internal control over finan- effective internal control over financial reporting as of December 31, cial reporting, assessing the risk that a material weakness exists, and 2015, based on criteria established in Internal Control - Integrated testing and evaluating the design and operating effectiveness of Framework (2013) issued by the COSO. internal control based on the assessed risk. Our audit also included We also have audited, in accordance with Canadian generally performing such other procedures as we considered necessary in accepted auditing standards and the standards of the Public the circumstances. We believe that our audit provides a reasonable Company Accounting Oversight Board (United States), the consoli- basis for our opinion. dated balance sheets of the Company as of December 31, 2015 A company’s internal control over financial reporting is a process and 2014, and the related consolidated statements of income, com- designed to provide reasonable assurance regarding the reliability prehensive income, changes in shareholders’ equity and cash flows of financial reporting and the preparation of financial statements for each of the years in the three-year period ended December 31, for external purposes in accordance with generally accepted 2015, and our report dated February 1, 2016 expressed an unquali- accounting principles. A company’s internal control over financial fied opinion on those consolidated financial statements. reporting includes those policies and procedures that (1) pertain to KPMG LLP* Montreal, Canada February 1, 2016 * FCPA auditor, FCA, public accountancy permit No. A106087 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. KPMG Canada provides services to KPMG LLP. CN | 2015 Annual Report 55 Consolidated Statements of Income and Comprehensive Income Consolidated Statements of Income In millions, except per share data Year ended December 31, 2015 2014 2013 Revenues Operating expenses Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses Operating income Interest expense Other income (Note 3) Income before income taxes Income tax expense (Note 4) Net income Earnings per share (Note 5) Basic Diluted Weighted-average number of shares (Note 5) Basic Diluted See accompanying notes to consolidated financial statements. Consolidated Statements of Comprehensive Income In millions Net income Other comprehensive income (loss) (Note 15) Net gain on foreign currency translation Net change in pension and other postretirement benefit plans (Note 12) Amortization of gain on treasury lock Other comprehensive income (loss) before income taxes Income tax recovery (expense) Other comprehensive income (loss) Comprehensive income See accompanying notes to consolidated financial statements. 56 CN | 2015 Annual Report $ 12,611 $ 12,134 $ 10,575 2,406 2,319 2,182 1,729 1,598 1,351 1,285 1,846 1,619 1,158 1,050 373 394 329 368 980 275 295 7,345 7,510 6,702 5,266 4,624 3,873 (439) 47 (371) 107 (357) 73 4,874 4,360 3,589 (1,336) (1,193) (977) $ 3,538 $ 3,167 $ 2,612 $ 4.42 $ 3.86 $ 3.10 $ 4.39 $ 3.85 $ 3.09 800.7 819.9 843.1 805.1 823.5 846.1 Year ended December 31, 2015 2014 2013 $ 3,538 $ 3,167 $ 2,612 249 306 - 555 105 660 75 46 (995) 1,775 (1) - (921) 1,821 344 (414) (577) 1,407 $ 4,198 $ 2,590 $ 4,019 Consolidated Balance Sheets In millions Assets Current assets Cash and cash equivalents Restricted cash and cash equivalents (Note 10) Accounts receivable (Note 6) Material and supplies Other Total current assets Properties (Note 7) Pension asset (Note 12) Intangible and other assets (Note 8) Total assets Liabilities and shareholders’ equity Current liabilities Accounts payable and other (Note 9) Current portion of long-term debt (Note 10) Total current liabilities Deferred income taxes (Note 4) Other liabilities and deferred credits (Note 11) Pension and other postretirement benefits (Note 12) Long-term debt (Note 10) Shareholders’ equity Common shares (Note 13) Common shares in Share Trusts (Note 13) Additional paid-in capital (Note 13) Accumulated other comprehensive loss (Note 15) Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity See accompanying notes to consolidated financial statements. On behalf of the Board: Robert Pace Director December 31, 2015 2014 $ 153 $ 52 523 878 355 244 463 928 335 215 2,153 1,993 32,624 28,514 1,305 320 882 298 $ 36,402 $ 31,687 $ 1,556 $ 1,657 1,442 544 2,998 2,201 8,105 6,834 644 720 704 650 8,985 7,828 3,705 3,718 (100) 475 - 439 (1,767) (2,427) 12,637 11,740 14,950 13,470 $ 36,402 $ 31,687 Claude Mongeau Director CN | 2015 Annual Report 57 Consolidated Statements of Changes in Shareholders’ Equity In millions Number of common shares Share Outstanding Trusts Common shares Common shares Additional paid-in capital in Share Trusts Accumulated other comprehensive loss Retained earnings Total shareholders’ equity Balance at December 31, 2012 856.8 - $ 3,892 $ - $ 216 $ (3,257) $ 10,167 $ 11,018 Net income Stock-based compensation Share repurchase programs (Note 13) Other comprehensive income (Note 15) Dividends ($0.86 per share) 1.4 (27.6) 36 (133) 4 2,612 2,612 40 (1,267) (1,400) (724) 1,407 (724) 1,407 Balance at December 31, 2013 830.6 - 3,795 - 220 (1,850) 10,788 12,953 Net income Stock-based compensation 1.2 31 10 Modification of stock-based compensation awards (Note 13) 209 Share repurchase programs (Note 13) (22.4) (108) Other comprehensive loss (Note 15) Dividends ($1.00 per share) 3,167 3,167 41 209 (577) (1,397) (1,505) (818) (577) (818) Balance at December 31, 2014 809.4 - 3,718 - 439 (2,427) 11,740 13,470 Net income Stock-based compensation Share repurchase programs (Note 13) 2.5 (23.3) 95 (108) 36 Share purchases by Share Trusts (Note 13) (1.4) 1.4 (100) Other comprehensive income (Note 15) Dividends ($1.25 per share) 3,538 (3) 3,538 128 (1,642) (1,750) 660 (996) (100) 660 (996) Balance at December 31, 2015 787.2 1.4 $ 3,705 $ (100) $ 475 $ (1,767) $ 12,637 $ 14,950 See accompanying notes to consolidated financial statements. 58 CN | 2015 Annual Report Consolidated Statements of Cash Flows In millions Operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Deferred income taxes (Note 4) Gain on disposal of property (Note 3) Changes in operating assets and liabilities: Accounts receivable Material and supplies Accounts payable and other Other current assets Pensions and other, net Year ended December 31, 2015 2014 2013 $ 3,538 $ 3,167 $ 2,612 1,158 1,050 600 - 188 4 (282) 46 (112) 416 (80) (59) (51) - 5 (67) 980 331 (69) 32 (38) (245) 13 (68) Net cash provided by operating activities 5,140 4,381 3,548 Investing activities Property additions Disposal of property (Note 3) Change in restricted cash and cash equivalents Other, net Net cash used in investing activities Financing activities Issuance of debt (Note 10) Repayment of debt (Note 10) Net issuance (repayment) of commercial paper (Note 10) Common shares issued for stock options exercised, excess tax benefits, and other (Note 14) Repurchase of common shares (Note 13) Purchase of common shares by Share Trusts (Note 13) Dividends paid Net cash used in financing activities Effect of foreign exchange fluctuations on US dollar-denominated cash and cash equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplemental cash flow information Net cash receipts from customers and other Net cash payments for: Employee services, suppliers and other expenses Interest Personal injury and other claims (Note 16) Pensions (Note 12) Income taxes (Note 4) Net cash provided by operating activities See accompanying notes to consolidated financial statements. (2,706) (2,297) (1,973) - (60) (61) 173 (15) (37) 52 73 (4) (2,827) (2,176) (1,852) 841 1,022 1,582 (752) 451 75 (822) (277) 30 (1,413) 268 31 (1,742) (1,505) (1,400) (100) (996) - - (818) (724) (2,223) (2,370) (1,656) 11 101 52 3 (162) 214 19 59 155 $ 153 $ 52 $ 214 $ 12,714 $ 12,029 $ 10,640 (6,232) (6,333) (5,558) (432) (59) (126) (725) (409) (57) (127) (722) (344) (61) (239) (890) $ 5,140 $ 4,381 $ 3,548 CN | 2015 Annual Report 59 Notes to Consolidated Financial Statements Canadian National Railway Company, together with its wholly-owned subsidiaries, collectively “CN” or the “Company,” is engaged in the rail and related transportation business. CN spans Canada and mid-America, from the Atlantic and Pacific oceans to the Gulf of Mexico, serving the ports of Vancouver, Prince Rupert (British Columbia), Montreal, Halifax, New Orleans and Mobile (Alabama), and the key metropolitan areas of Toronto, Buffalo, Chicago, Detroit, Duluth (Minnesota)/Superior (Wisconsin), Green Bay (Wisconsin), Minneapolis/St. Paul, Memphis, and Jackson (Mississippi), with connections to all points in North America. CN’s freight revenues are derived from the movement of a diversified and balanced portfolio of goods, including petroleum and chemicals, grain and fertilizers, coal, metals and minerals, forest products, intermodal and automotive. 1 | Summary of significant accounting policies Deferred income tax assets and liabilities are measured using enacted Basis of presentation tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. These consolidated financial statements are expressed in Canadian dollars, except where otherwise indicated, and have been prepared Earnings per share in accordance with United States generally accepted accounting Basic earnings per share is calculated based on the weighted-average principles (U.S. GAAP) as codified in the Financial Accounting number of common shares outstanding over each period. The Standards Board (FASB) Accounting Standards Codification (ASC). weighted-average number of basic shares outstanding excludes Principles of consolidation shares held in the Share Trusts and includes fully vested equity settled stock-based compensation awards excluding stock options. Diluted These consolidated financial statements include the accounts of all earnings per share is calculated based on the weighted-average num- subsidiaries and variable interest entities for which the Company is ber of diluted shares outstanding using the treasury stock method. the primary beneficiary. The Company is the primary beneficiary of Included in the diluted earnings per share calculation are the assumed the Employee Benefit Plan Trusts (“Share Trusts”) as the Company issuances of non-vested stock-based compensation awards. funds the Share Trusts. The Company’s investments in which it has significant influence are accounted for using the equity method and Foreign currency all other investments are accounted for using the cost method. All of the Company’s United States (U.S.) subsidiaries use the US Use of estimates dollar as their functional currency. Accordingly, the U.S. subsidiaries’ assets and liabilities are translated into Canadian dollars at the rate The preparation of financial statements in conformity with U.S. GAAP in effect at the balance sheet date and the revenues and expenses requires management to make estimates and assumptions that affect are translated at average exchange rates during the year. All the reported amounts of revenues, expenses, assets and liabilities, adjustments resulting from the translation of the foreign operations and the disclosure of contingent assets and liabilities at the date of are recorded in Other comprehensive income (loss). the financial statements. On an ongoing basis, management reviews The Company designates the US dollar-denominated long-term its estimates, including those related to income taxes, depreciation, debt of the parent company as a foreign currency hedge of its net pensions and other postretirement benefits, personal injury and other investment in U.S. subsidiaries. Accordingly, foreign exchange gains claims, and environmental matters, based upon available information. and losses, from the dates of designation, on the translation of the Actual results could differ from these estimates. US dollar-denominated long-term debt are also included in Other comprehensive income (loss). Revenues Freight revenues are recognized using the percentage of completed Cash and cash equivalents service method based on the transit time of freight as it moves from Cash and cash equivalents include highly liquid investments pur- origin to destination. The allocation of revenues between reporting chased three months or less from maturity and are stated at cost, periods is based on the relative transit time in each period with which approximates market value. expenses being recorded as incurred. Revenues related to non-rail transportation services are recognized as service is performed or as Restricted cash and cash equivalents contractual obligations are met. Revenues are presented net of taxes The Company has the option, under its bilateral letter of credit collected from customers and remitted to governmental authorities. facility agreements with various banks, to pledge collateral in the Income taxes form of cash and cash equivalents for a minimum term of one month, equal to at least the face value of the letters of credit The Company follows the asset and liability method of accounting issued. Restricted cash and cash equivalents are shown separately for income taxes. Under the asset and liability method, the change on the balance sheet and include highly liquid investments pur- in the net deferred income tax asset or liability is included in the chased three months or less from maturity and are stated at cost, computation of Net income or Other comprehensive income (loss). which approximates market value. 60 CN | 2015 Annual Report Accounts receivable costs include, but are not limited to, fringe benefits, small tools and Accounts receivable are recorded at cost net of billing adjustments supplies, maintenance on equipment used on projects and project and an allowance for doubtful accounts. The allowance for doubtful supervision. The Company reviews and adjusts its allocations, as accounts is based on expected collectability and considers historical required, to reflect the actual costs incurred each year. experience as well as known trends or uncertainties related to account For the rail asset, the Company capitalizes the costs of rail collectability. When a receivable is deemed uncollectible, it is written grinding which consists of restoring and improving the rail profile off against the allowance for doubtful accounts. Subsequent recoveries and removing irregularities from worn rail to extend the service of amounts previously written off are credited to bad debt expense in life. The service life of the rail asset is increased incrementally as rail Casualty and other in the Consolidated Statement of Income. grinding is performed thereon, and as such, the costs incurred are Material and supplies capitalized given that the activity extends the service life of the rail asset beyond its original or current condition as additional gross Material and supplies, which consist mainly of rail, ties, and other tons can be carried over the rail for its remaining service life. items for construction and maintenance of property and equipment, For the ballast asset, the Company engages in shoulder ballast as well as diesel fuel, are valued at weighted-average cost. undercutting that consists of removing some or all of the ballast, which Properties has deteriorated over its service life, and replacing it with new ballast. When ballast is installed as part of a shoulder ballast undercutting Accounting policy for capitalization of costs project, it represents the addition of a new asset and not the repair or The Company’s railroad operations are highly capital intensive. maintenance of an existing asset. As such, the Company capitalizes The Company’s properties mainly consist of homogeneous or expenditures related to shoulder ballast undercutting given that an network-type assets such as rail, ties, ballast and other structures, existing asset is retired and replaced with a new asset. Under the group which form the Company’s Track and roadway properties, and method of accounting for properties, the deteriorated ballast is retired Rolling stock. The Company’s capital expenditures are for the re- at its average cost measured using the quantities of new ballast added. placement of existing assets and for the purchase or construction of Costs of deconstruction and removal of replaced assets, referred to new assets to enhance operations or provide new service offerings herein as dismantling costs, are distinguished from installation costs for to customers. A large portion of the Company’s capital expenditures self-constructed properties based on the nature of the related activity. are for self-constructed properties including the replacement of For Track and roadway properties, employees concurrently perform existing track and roadway assets and track line expansion, as well dismantling and installation of new track and roadway assets and, as as major overhauls and large refurbishments of rolling stock. such, the Company estimates the amount of labor and other costs that Expenditures are generally capitalized if they extend the life are related to dismantling. The Company determines dismantling costs of the asset or provide future benefits such as increased revenue- based on an analysis of the track and roadway installation process. generating capacity, functionality, or physical or service capacity. Expenditures relating to the Company’s properties that do not The Company has a process in place to determine whether its meet the Company’s capitalization criteria are considered normal capital programs qualify for capitalization. For Track and roadway repairs and maintenance and are expensed. For Track and roadway properties, the Company establishes basic capital programs to properties, such expenditures include but are not limited to spot replace or upgrade the track infrastructure assets which are tie replacement, spot or broken rail replacement, physical track capitalized if they meet the capitalization criteria. inspection for detection of rail defects and minor track corrections, In addition, for Track and roadway properties, expenditures that and other general maintenance of track infrastructure. meet the minimum level of activity as defined by the Company are also capitalized as follows: Accounting policy for depreciation • grading: installation of road bed, retaining walls, drainage structures; Railroad properties are carried at cost less accumulated depreciation • rail and related track material: installation of 39 or more including asset impairment write-downs. The cost of properties, continuous feet of rail; including those under capital leases, net of asset impairment write- • ties: installation of 5 or more ties per 39 feet; and downs, is depreciated on a straight-line basis over their estimated • ballast: installation of 171 cubic yards of ballast per mile. service lives, measured in years, except for rail which is measured For purchased assets, the Company capitalizes all costs necessary method of depreciation whereby a single composite depreciation to make the asset ready for its intended use. Expenditures that are rate is applied to the gross investment in a class of similar assets, capitalized as part of self-constructed properties include direct ma- despite small differences in the service life or salvage value of terial, labor, and contracted services, as well as other allocated costs individual property units within the same asset class. The Company which are not charged directly to capital projects. These allocated uses approximately 40 different depreciable asset classes. in millions of gross ton miles. The Company follows the group CN | 2015 Annual Report 61 Notes to Consolidated Financial Statements 1 | Summary of significant accounting policies continued • the amortization of prior service costs and amendments over the expected average remaining service life of the employee group covered by the plans; and For all depreciable assets, the depreciation rate is based on the • the amortization of cumulative net actuarial gains and losses in estimated service lives of the assets. Assessing the reasonableness of the estimated service lives of properties requires judgment and is based on currently available information, including periodic depreci- excess of 10% of the greater of the beginning of year balances of the projected benefit obligation or market-related value of plan assets, over the expected average remaining service life of ation studies conducted by the Company. The Company’s U.S. prop- the employee group covered by the plans. erties are subject to comprehensive depreciation studies as required by the Surface Transportation Board (STB) and are conducted by The pension plans are funded through contributions determined in external experts. Depreciation studies for Canadian properties are accordance with the projected unit credit actuarial cost method. not required by regulation and are conducted internally. Studies are performed on specific asset groups on a periodic basis. Changes in Postretirement benefits other than pensions the estimated service lives of the assets and their related composite The Company accrues the cost of postretirement benefits other than depreciation rates are implemented prospectively. The service life of the rail asset is based on expected future pensions using actuarial methods. These benefits, which are funded as they become due, include life insurance programs, medical benefits usage of the rail in its existing condition, determined using railroad and, for a closed group of employees, free rail travel benefits. industry research and testing (based on rail characteristics such as weight, curvature and metallurgy), less the rail asset’s usage to date. The annual composite depreciation rate for rail assets is The Company amortizes the cumulative net actuarial gains and losses in excess of 10% of the projected benefit obligation at the beginning of the year, over the expected average remaining service determined by dividing the estimated annual number of gross tons life of the employee group covered by the plan. carried over the rail by the estimated service life of the rail measured in millions of gross ton miles. The Company amortizes the cost of Stock-based compensation rail grinding over the remaining life of the rail asset, which includes For equity settled awards, stock-based compensation costs are the incremental life extension generated by rail grinding. Intangible assets Intangible assets consist mainly of customer contracts and relation- ships assumed through past acquisitions and are being amortized on a straight-line basis over 40 to 50 years. accrued over the requisite service period based on the fair value of the awards at the grant date. The fair value of performance share unit (PSU) awards is dependent on the type of PSU award. The fair value of PSU-ROIC awards is determined using a lattice-based model and the fair value of PSU-TSR awards is determined using a Monte Carlo simulation model. The fair value of deferred share unit The Company reviews the carrying amounts of intangible assets (DSU) awards is determined using the stock price at the grant date. held and used whenever events or changes in circumstances indi- cate that such carrying amounts may not be recoverable based on The fair value of stock option awards is determined using the Black- Scholes option-pricing model. For cash settled awards, the fair value future undiscounted cash flows. Assets that are deemed impaired as of the awards are accrued over the requisite service period based on a result of such review are recorded at the lower of carrying amount the fair value determined at each period-end. or fair value. Accounts receivable securitization Based on the structure of its accounts receivable securitization program, the Company accounts for the proceeds received as a secured borrowing. Pensions Personal injury and other claims In Canada, the Company accounts for costs related to employee work-related injuries based on actuarially developed estimates on a discounted basis of the ultimate cost associated with such injuries, in- cluding compensation, health care and third-party administration costs. In the U.S., the Company accrues the expected cost for personal injury, property damage and occupational disease claims, based on Pension costs are determined using actuarial methods. Net periodic actuarial estimates of their ultimate cost on an undiscounted basis. benefit cost is charged to income and includes: • the cost of pension benefits provided in exchange for employees’ services rendered during the year; the interest cost of pension obligations; the expected long-term return on pension fund assets; • • For all other legal actions in Canada and the U.S., the Company maintains, and regularly updates on a case-by-case basis, provisions for such items when the expected loss is both probable and can be reasonably estimated based on currently available information. 62 CN | 2015 Annual Report Notes to Consolidated Financial Statements Environmental expenditures other parties are recorded as assets when their receipt is deemed Environmental expenditures that relate to current operations, or to probable and collectability is reasonably assured. an existing condition caused by past operations, are expensed unless they can contribute to current or future operations. Environmental Derivative financial instruments liabilities are recorded when environmental assessments occur, re- The Company uses derivative financial instruments from time to medial efforts are probable, and when the costs, based on a specific time in the management of its interest rate and foreign currency plan of action in terms of the technology to be used and the extent exposures. Derivative instruments are recorded on the balance sheet of the corrective action required, can be reasonably estimated. The at fair value and the changes in fair value are recorded in Net income Company accrues its allocable share of liability taking into account or Other comprehensive income (loss) depending on the nature and the Company’s alleged responsibility, the number of potentially effectiveness of the hedge transaction. Income and expense related responsible parties and their ability to pay their respective shares to hedged derivative financial instruments are recorded in the same of the liability. Recoveries of environmental remediation costs from category as that generated by the underlying asset or liability. 2 | Recent accounting pronouncements The following recent Accounting Standards Updates (ASUs) issued by FASB were adopted by the Company during the current period: Standard Description Impact ASU 2015-17 Simplifies the presentation of deferred income The Company adopted this standard during the fourth quarter Income Taxes, taxes by requiring that deferred tax liabilities and of 2015 on a retrospective basis. The current deferred income Balance Sheet assets be classified as noncurrent in a statement of tax asset was reclassified as noncurrent and netted against the Classification of financial position, thus eliminating the requirement related noncurrent deferred income tax liability in the amount of Deferred Taxes to separate deferred income tax liabilities and assets $58 million and $68 million as at December 31, 2015 and 2014, into current and noncurrent amounts. respectively. ASU 2015-03 Simplifies the presentation of debt issuance costs The Company adopted this standard during the fourth quarter of Interest – by requiring that such costs be presented in the 2015 on a retrospective basis. Debt issuance costs have been reclassi- Imputation of balance sheet as a deduction from the carrying fied from assets to Long-term debt in the amount of $42 million and Interest amount of debt. $37 million as at December 31, 2015 and 2014, respectively. The following recent ASUs issued by FASB have an effective date after December 31, 2015 and have not been adopted by the Company: Standard Description Impact Effective date (1) ASU 2016-01 Addresses certain aspects of recognition, measurement, The Company is December 15, 2017. Financial presentation, and disclosure of financial instruments. The evaluating the effect that Instruments – amendments require equity investments (except those accounted the ASU will have on its Overall for under the equity method of accounting or those resulting in Consolidated Financial consolidation) to be measured at fair value with changes in fair Statements, if any; value recognized in net income. The new guidance can be applied however, no significant by means of a cumulative effect adjustment to the balance sheet impact is expected. at the beginning of the year of adoption. ASU 2014-09 Establishes principles for reporting the nature, amount, timing and The Company is December 15, 2017. Revenue from uncertainty of revenues and cash flows arising from an entity’s evaluating the effect that Early adoption is Contracts with contracts with customers. The basis of the new standard is that the ASU will have on its permitted. Customers an entity recognizes revenue to represent the transfer of goods or Consolidated Financial services to customers in an amount that reflects the consideration Statements, if any; to which the entity expects to be entitled in exchange for those however, no significant goods or services. The new guidance can be applied using a impact is expected. retrospective or the cumulative effect transition method. (1) Effective for annual and interim reporting periods beginning after the stated date. CN | 2015 Annual Report 63 Notes to Consolidated Financial Statements 2013 Exchange of easements On June 8, 2013, the Company entered into an agreement with another Class I railroad to exchange perpetual railroad operating easements including the track and roadway assets on specific rail lines (collectively the “exchange of easements”) without monetary consideration. The Company accounted for the exchange of easements at fair value pursuant to FASB ASC 845, Nonmonetary Transactions. The transaction resulted in a gain on exchange of easements of $29 million ($18 million after-tax) that was recorded in Other income. Lakeshore West On March 19, 2013, the Company entered into an agreement with Metrolinx to sell a segment of the Oakville subdivision in Oakville and Burlington, Ontario, together with the rail fixtures and certain passenger agreements (collectively the “Lakeshore West”), for cash proceeds of $52 million before transaction costs. Under the agree- ment, the Company obtained the perpetual right to operate freight trains over the Lakeshore West at its then current level of operating activity, with the possibility of increasing its operating activity for additional consideration. The transaction resulted in a gain on disposal of $40 million ($36 million after-tax) that was recorded in Other income under the full accrual method of accounting for real estate transactions. 3 | Other income In millions Year ended December 31, 2015 2014 2013 Gain on disposal of property (1) $ - $ 99 $ 64 Gain on disposal of land Other (2) Total other income 52 (5) 21 (13) 19 (10) $ 47 $ 107 $ 73 (1) (2) In addition to the disposals of property described herein, 2014 includes other gains of $19 million and 2013 includes other losses of $5 million. Includes foreign exchange gains and losses related to foreign exchange forward contracts and the re-measurement of other US dollar-denominated monetary assets and liabilities. See Note 17 – Financial instruments. Disposal of property 2014 Guelph On September 4, 2014, the Company closed a transaction with Metrolinx to sell a segment of the Guelph subdivision located between Georgetown and Kitchener, Ontario, together with the rail fixtures and certain passenger agreements (collectively the “Guelph”), for cash proceeds of $76 million before transaction costs. The Company did not meet all the conditions to record the sale under the full accrual method for real estate transactions as it continues to have substantial continuing involvement on the Guelph. The Company will have relinquished substantially all of the risks and rewards of ownership on the Guelph in 2018, at which time the gain on the sale is expected to be recognized. Deux-Montagnes On February 28, 2014, the Company closed a transaction with Agence Métropolitaine de Transport to sell the Deux-Montagnes subdivision between Saint-Eustache and Montreal, Quebec, including the Mont-Royal tunnel, together with the rail fixtures (collectively the “Deux-Montagnes”), for cash proceeds of $97 million before transaction costs. Under the agreement, the Company obtained the perpetual right to operate freight trains over the Deux-Montagnes at its then current level of operating activity, with the possibility of increasing its operating activity for additional consideration. The transaction resulted in a gain on disposal of $80 million ($72 million after-tax) that was recorded in Other income under the full accrual method of accounting for real estate transactions. 64 CN | 2015 Annual Report Notes to Consolidated Financial Statements 4 | Income taxes The Company’s consolidated effective income tax rate differs from the Canadian, or domestic, statutory federal tax rate. The effective tax rate is affected by recurring items such as tax rates in provincial, U.S. federal, state and other foreign jurisdictions and the proportion of income earned in those jurisdictions. The effective tax rate is also affected by discrete items such as income tax rate enactments and lower tax rates on capital dispositions that may occur in any given year. The following table provides a reconciliation of income tax expense: In millions Year ended December 31, 2015 2014 2013 Canadian statutory federal tax rate 15% 15% 15% Income tax expense at the The following table provides the significant components of deferred income tax assets and liabilities: In millions December 31, 2015 2014 Deferred income tax assets Pension liability Personal injury and legal claims Environmental and other reserves Other postretirement benefits liability Unrealized foreign exchange losses Net operating losses and tax credit carryforwards (1) $ 147 $ 120 64 179 82 124 26 60 173 80 - 20 Total deferred income tax assets $ 622 $ 453 Canadian statutory federal tax rate $ 731 $ 654 $ 538 Other (2) Income tax expense (recovery) resulting from: Provincial and foreign taxes (1) 550 531 423 Deferred income tax adjustments due to rate enactments (2) Gain on disposals (3) Other (4) Income tax expense 42 (11) 24 - (19) 27 24 (9) 1 $ 1,336 $ 1,193 $ 977 Total net deferred income tax liability Deferred income tax liabilities Properties Pension asset Unrealized foreign exchange gains (2) Total deferred income tax liabilities Total net deferred income tax liability Total net deferred income tax liability Domestic Foreign $ 8,303 $ 6,946 348 - 76 232 68 41 $ 8,727 $ 7,287 $ 8,105 $ 6,834 $ 3,074 $ 2,841 5,031 3,993 $ 8,105 $ 6,834 Cash payments for income taxes $ 725 $ 722 $ 890 (1) Net operating losses and tax credit carryforwards will expire between the years 2018 and (1) Includes mainly the impact of Canadian provincial taxes and U.S. federal and state taxes. (2) Includes the net income tax expense resulting from the enactment of provincial corporate tax rates. (3) Relates to the permanent differences arising from lower capital gain tax rates on the gain on disposal of the Company’s properties in Canada. (4) Includes adjustments relating to the resolution of matters pertaining to prior years’ income taxes, including net recognized tax benefits, and other items. The following table provides tax information on a domestic and foreign basis: 2035. (2) Certain 2014 balances have been reclassified to conform with the 2015 presentation. On an annual basis, the Company assesses the need to establish a valuation allowance for its deferred income tax assets, and if it is deemed more likely than not that its deferred income tax assets will not be realized, a valuation allowance is recorded. The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the per- iods in which those temporary differences become deductible. In millions Year ended December 31, 2015 2014 2013 Management considers the scheduled reversals of deferred income Income before income taxes Domestic Foreign $ 3,437 $ 3,042 $ 2,445 1,437 1,318 1,144 Total income before income taxes $ 4,874 $ 4,360 $ 3,589 Current income tax expense Domestic Foreign $ 640 $ 522 $ 404 96 255 242 Total current income tax expense $ 736 $ 777 $ 646 Deferred income tax expense Domestic Foreign $ 328 $ 271 $ 279 272 145 52 Total deferred income tax expense $ 600 $ 416 $ 331 tax liabilities, the available carryback and carryforward periods, and projected future taxable income in making this assessment. As at December 31, 2015, in order to fully realize all of the deferred income tax assets, the Company will need to generate future taxable income of approximately $2.2 billion and, based upon the level of historical taxable income and projections of future taxable income over the periods in which the deferred income tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences. Management has assessed the impacts of the current economic environment and concluded there are no significant impacts to its assertions for the realization of deferred income tax assets. The Company has not recognized a deferred income tax asset of $234 million as at December 31, 2015 ($270 million as CN | 2015 Annual Report 65 Notes to Consolidated Financial Statements 4 | Income taxes continued at December 31, 2014) on the unrealized foreign exchange loss in progress and is expected to be completed during 2016. In the U.S., the federal income tax returns filed for the years 2012 to 2014 and the state income tax returns filed for the years 2011 to 2014 remain subject to examination by the taxation authorities. recorded in Accumulated other comprehensive loss relating to its Examinations of certain state income tax returns by the state net investment in U.S. subsidiaries, as the Company does not expect taxation authorities are currently in progress. The Company does this temporary difference to reverse in the foreseeable future. not anticipate any significant impacts to its results of operations or financial position as a result of the final resolutions of such matters. 5 | Earnings per share The following table provides a reconciliation between basic and diluted earnings per share: In millions, except per share data Year ended December 31, 2015 2014 2013 Net income $ 3,538 $ 3,167 $ 2,612 Weighted-average basic shares outstanding 800.7 819.9 843.1 Dilutive effect of stock-based compensation 4.4 3.6 3.0 Weighted-average diluted shares outstanding 805.1 823.5 846.1 Basic earnings per share $ 4.42 $ 3.86 $ 3.10 Diluted earnings per share $ 4.39 $ 3.85 $ 3.09 6 | Accounts receivable In millions Freight Non-freight Gross accounts receivable Allowance for doubtful accounts Net accounts receivable December 31, 2015 2014 $ 705 $ 777 180 885 (7) 160 937 (9) $ 878 $ 928 The following table provides a reconciliation of unrecognized tax benefits on the Company’s domestic and foreign tax positions: In millions Year ended December 31, 2015 2014 2013 Gross unrecognized tax benefits at beginning of year $ 35 $ 30 $ 36 Increases for: Tax positions related to the current year Tax positions related to prior years Decreases for: Tax positions related to prior years Settlements Lapse of the applicable statute of limitations Gross unrecognized tax benefits at 4 8 - (14) (6) 3 3 - - (1) 2 4 (4) (8) - end of year $ 27 $ 35 $ 30 Adjustments to reflect tax treaties and other arrangements (8) (6) (5) Net unrecognized tax benefits at end of year $ 19 $ 29 $ 25 As at December 31, 2015, the total amount of gross unrecog- nized tax benefits was $27 million, before considering tax treaties and other arrangements between taxation authorities. The amount of net unrecognized tax benefits as at December 31, 2015 was $19 million. If recognized, all of the net unrecognized tax benefits as at December 31, 2015 would affect the effective tax rate. The Company believes that it is reasonably possible that approximately $5 million of the net unrecognized tax benefits as at December 31, 2015 related to various federal, state, and provincial income tax matters, each of which are individually insignificant, may be recognized over the next twelve months as a result of settlements and a lapse of the applicable statute of limitations. The Company recognizes accrued interest and penalties related to gross unrecognized tax benefits in Income tax expense in the Company’s Consolidated Statement of Income. The Company recognized approximately $1 million, $1 million and $2 million in accrued interest and penalties during the years ended December 31, 2015, 2014 and 2013, respectively. The Company had approximate- ly $4 million and $6 million of accrued interest and penalties as at December 31, 2015 and 2014, respectively. In Canada, the Company’s federal and provincial income tax returns filed for the years 2011 to 2014 remain subject to examin- ation by the taxation authorities. An examination of the Company’s federal income tax returns for the years 2011 and 2012 is currently 66 CN | 2015 Annual Report Notes to Consolidated Financial Statements 7 | Properties In millions Properties including capital leases Track and roadway (1) Rolling stock Buildings Information technology (2) Other Depreciation rate December 31, 2015 Accumulated Cost depreciation Net December 31, 2014 Accumulated depreciation Cost Net 2% 5% 2% 10% 4% $ 33,941 $ 7,830 $ 26,111 $ 29,995 $ 7,332 $ 22,663 6,216 1,791 1,067 1,812 2,362 624 567 820 3,854 1,167 500 992 5,552 1,545 1,068 1,549 2,107 3,445 560 492 704 985 576 845 Total properties including capital leases $ 44,827 $ 12,203 $ 32,624 $ 39,709 $ 11,195 $ 28,514 Capital leases included in properties Track and roadway (3) $ 415 $ 66 $ 349 $ 417 $ 63 $ Rolling stock Buildings Other 748 109 122 301 26 36 447 83 86 808 109 108 292 23 29 354 516 86 79 Total capital leases included in properties $ 1,394 $ 429 $ 965 $ 1,442 $ 407 $ 1,035 (1) Includes $2,487 million of land as at December 31, 2015 ($2,079 million as at December 31, 2014). (2) The Company capitalized $85 million of costs for internally developed software in 2015 ($102 million in 2014). (3) Includes $108 million of right-of-way access as at December 31, 2015 ($108 million as at December 31, 2014). 8 | Intangible and other assets 9 | Accounts payable and other In millions December 31, 2015 2014 In millions December 31, 2015 2014 Deferred and long-term receivables $ 144 $ 141 Trade payables $ 391 $ 464 Intangible assets Investments (1) Other (2) 71 69 36 62 58 37 Payroll-related accruals Income and other taxes Accrued charges Total intangible and other assets $ 320 $ 298 Accrued interest (1) As at December 31, 2015, the Company had $56 million ($47 million as at December 31, 2014) of investments accounted for under the equity method and $13 million ($11 million as at December 31, 2014) of investments accounted for under the cost method. See Note 17 - Financial instruments for the fair value of Investments. (2) As a result of the retrospective adoption of a new accounting standard in the fourth quarter of 2015, debt issuance costs have been reclassified from assets to Long-term debt. See Note 2 - Recent accounting pronouncements for additional information. Personal injury and other claims provisions (Note 16) Environmental provisions (Note 16) Stock-based compensation liability (Note 14) Other postretirement benefits liability (Note 12) Other 287 254 192 122 51 51 39 18 151 317 208 166 95 48 45 106 17 191 Total accounts payable and other $ 1,556 $ 1,657 CN | 2015 Annual Report 67 Notes to Consolidated Financial Statements 10 | Long-term debt In millions Notes and debentures (1) Canadian National series: - 2-year floating rate notes 5.80% 1.45% 10-year notes (2) 5-year notes (2) - 3-year floating rate notes (3) 5.85% 5.55% 6.80% 5.55% 2.75% 2.85% 2.25% 7.63% 2.95% 2.80% 6.90% 7.38% 6.25% 6.20% 6.71% 6.38% 3.50% 4.50% 3.95% 4.00% 10-year notes (2) 10-year notes (2) 20-year notes (2) 10-year notes (2) 7-year notes (2) 10-year notes (2) 10-year notes (2) 30-year debentures 10-year notes (2) 10-year notes (2) 30-year notes (2) 30-year debentures (2) 30-year notes (2) 30-year notes (2) Puttable Reset Securities PURSSM (2) 30-year debentures (2) 30-year notes (2) 30-year notes (2) 30-year notes (2) 50-year notes (2) Nov. 6, 2015 June 1, 2016 Dec. 15, 2016 Nov. 14, 2017 Nov. 15, 2017 May 15, 2018 July 15, 2018 Mar. 1, 2019 Feb. 18, 2021 Dec. 15, 2021 Nov. 15, 2022 May 15, 2023 Nov. 21, 2024 Sep. 22, 2025 July 15, 2028 Oct. 15, 2031 Aug. 1, 2034 June 1, 2036 July 15, 2036 Nov. 15, 2037 Nov. 15, 2042 Nov. 7, 2043 Sep. 22, 2045 Sep. 22, 2065 Illinois Central series: 7.70% 100-year debentures Sep. 15, 2096 BC Rail series: Non-interest bearing 90-year subordinated notes (4) July 14, 2094 Total notes and debentures Other Commercial paper Accounts receivable securitization Capital lease obligations Total debt, gross Net unamortized discount and debt issuance costs (4) (5) Total debt (6) Less: Current portion of long-term debt Total long-term debt Maturity US dollar- denominated amount December 31, 2015 2014 US$ 350 $ - $ 250 300 250 250 325 200 550 - 400 250 150 350 - 475 200 500 450 250 300 250 250 - - 125 - 346 415 346 346 450 277 761 250 554 346 208 484 350 657 277 692 623 346 415 346 346 400 100 406 290 348 290 290 377 232 638 250 464 290 174 406 - 551 232 581 522 290 348 290 290 - - 173 145 842 842 $ 10,350 $ 8,546 458 - 522 11,330 (903) 10,427 1,442 - 50 670 9,266 (894) 8,372 544 $ 8,985 $ 7,828 (1) The Company’s notes, debentures and revolving credit facility are unsecured. (2) The fixed rate debt securities are redeemable, in whole or in part, at the option of the Company, at any time, at the greater of par and a formula price based on interest rates prevailing at the time of redemption. (3) These floating rate notes bear interest at the three-month London Interbank Offered Rate (LIBOR) plus 0.17%. The interest rate as at December 31, 2015 was 0.53% (0.40% as at December 31, 2014). (4) The Company records these notes as a discounted debt of $10 million as at December 31, 2015 ($9 million as at December 31, 2014) using an imputed interest rate of 5.75% (5.75% as at December 31, 2014). The discount of $832 million ($833 million as at December 31, 2014) is included in Net unamortized discount and debt issuance costs. (5) As a result of the retrospective adoption of a new accounting standard in the fourth quarter of 2015, debt issuance costs have been reclassified from assets to Long-term debt. See Note 2 - Recent accounting pronouncements for additional information. (6) See Note 17 - Financial instruments for the fair value of debt. 68 CN | 2015 Annual Report Notes to Consolidated Financial Statements Revolving credit facility Bilateral letter of credit facilities The Company has an $800 million revolving credit facility agreement The Company has a series of bilateral letter of credit facility with a consortium of lenders. The agreement, which contains custom- agreements with various banks to support its requirements to post ary terms and conditions, allows for an increase in the facility amount, letters of credit in the ordinary course of business. On March 12, up to a maximum of $1.3 billion, as well as the option to extend the 2015, the Company extended the expiry date of its agreements by term by an additional year at each anniversary date, subject to the one year to April 28, 2018. Under these agreements, the Company consent of individual lenders. The Company exercised such option and has the option from time to time to pledge collateral in the form on March 12, 2015, the expiry date of the agreement was extended of cash or cash equivalents, for a minimum term of one month, by one year to May 5, 2020. The credit facility is available for general equal to at least the face value of the letters of credit issued. As at corporate purposes, including backstopping the Company’s commer- December 31, 2015, the Company had letters of credit drawn of cial paper programs, and provides for borrowings at various interest $551 million ($487 million as at December 31, 2014) from a total rates, including the Canadian prime rate, bankers’ acceptance rates, committed amount of $575 million ($511 million as at December 31, the U.S. federal funds effective rate and the London Interbank Offered 2014) by the various banks. As at December 31, 2015, cash and Rate (LIBOR), plus applicable margins. The credit facility agreement cash equivalents of $523 million ($463 million as at December 31, has one financial covenant, which limits debt as a percentage of total 2014) were pledged as collateral and recorded as Restricted cash capitalization, and with which the Company is in compliance. As at and cash equivalents on the Consolidated Balance Sheet. December 31, 2015 and 2014, the Company had no outstanding borrowings under its revolving credit facility and there were no draws Capital lease obligations during the years ended December 31, 2015 and 2014. The Company had no acquisitions of assets through equipment Commercial paper leases in 2015 and 2014. Interest rates for capital lease obligations range from 0.7% to 7.3% with maturity dates in the years 2016 The Company has a commercial paper program in Canada and a through 2037. The imputed interest on these leases amounted new commercial paper program was established in the U.S. during to $118 million as at December 31, 2015 ($145 million as at the second quarter of 2015. Both programs are backstopped by the December 31, 2014). The capital lease obligations are secured Company’s revolving credit facility, enabling it to issue commercial by properties with a net carrying amount of $603 million as at paper up to a maximum aggregate principal amount of $800 million, December 31, 2015 ($668 million as at December 31, 2014). or the US dollar equivalent, on a combined basis. As at December 31, 2015, the Company had total commercial paper borrowings of Long-term debt maturities US$331 million ($458 million) (nil as at December 31, 2014) at The following table provides the long-term debt maturities, a weighted-average interest rate of 0.41% presented in Current including capital lease repayments on debt outstanding as at portion of long-term debt on the Consolidated Balance Sheet. The December 31, 2015, for the next five years and thereafter: Company’s commercial paper has a maturity less than 90 days. The following table presents the issuances and repayments of commercial paper: In millions Year ended December 31, 2015 2014 2013 Issuances of commercial paper $ 2,624 $ 2,443 $ 3,255 Repayments of commercial paper (2,173) (2,720) (2,987) Net issuance (repayment) of commercial paper $ 451 $ (277) $ 268 Accounts receivable securitization program In millions 2016 (1) 2017 2018 2019 2020 2021 and thereafter Total Capital leases Debt Total $ 223 $ 1,219 $ 1,442 174 9 10 16 90 684 720 755 - 858 729 765 16 6,527 6,617 $ 522 $ 9,905 $ 10,427 The Company has an agreement to sell an undivided co-ownership (1) Current portion of long-term debt. interest in a revolving pool of accounts receivable to unrelated trusts for maximum cash proceeds of $450 million. On June 18, Amount of US dollar-denominated debt 2015, the Company extended the term of its agreement by one year to February 1, 2018. As at December 31, 2015, the Company had no proceeds ($50 million at a weighted-average interest rate of 1.24%, which was secured by, and limited to, $56 million of accounts receivable as at December 31, 2014) received under the accounts receivable securitization program in the Current portion of long-term debt on the Consolidated Balance Sheet. In millions December 31, 2015 2014 Notes and debentures Commercial paper Capital lease obligations US $ 6,075 US $ 6,425 331 274 - 448 Total amount of US dollar-denominated debt in US$ US $ 6,680 US $ 6,873 Total amount of US dollar-denominated debt in C$ $ 9,245 $ 7,973 CN | 2015 Annual Report 69 Notes to Consolidated Financial Statements 11 | Other liabilities and deferred credits In millions December 31, 2015 2014 Personal injury and other claims provisions (Note 16) (1) $ 245 $ 250 Stock-based compensation liability (Note 14) (1) Environmental provisions (Note 16) (1) Deferred credits and other 63 59 277 91 69 294 Total other liabilities and deferred credits $ 644 $ 704 (1) See Note 9 – Accounts payable and other for the related current portion. 12 | Pensions and other postretirement benefits The Company has various retirement benefit plans under which sub- stantially all of its employees are entitled to benefits at retirement age, generally based on compensation and length of service and/or contributions. Senior and executive management employees subject to certain minimum service and age requirements, are also eligible for an additional retirement benefit under their Special Retirement Stipend Agreements, the Supplemental Executive Retirement Plan or the Defined Contribution Supplemental Executive Retirement Plan. The Company also offers postretirement benefits to certain employ- ees providing life insurance, medical benefits and, for a closed group of employees, free rail travel benefits during retirement. These postretire- ment benefits are funded as they become due. The information in the tables that follow pertains to all of the Company’s defined benefit plans. However, the following descriptions relate solely to the Company’s main pension plan, the CN Pension Plan, unless otherwise specified. Description of the CN Pension Plan The CN Pension Plan is a contributory defined benefit pension plan that covers the majority of CN employees. It provides for pensions based mainly on years of service and final average pensionable earnings and is generally applicable from the first day of employment. Indexation of pensions is provided after retirement through a gain/ loss sharing mechanism, subject to guaranteed minimum increases. An independent trust company is the Trustee of the Company’s pension trust funds (including the CN Pension Trust Fund). As Trustee, the trust company performs certain duties, which include holding legal title to the assets of the CN Pension Trust Fund and ensuring that the Company, as Administrator, complies with the provisions of the CN Pension Plan and the related legislation. The Company utilizes a measurement date of December 31 for the CN Pension Plan. Funding policy Employee contributions to the CN Pension Plan are determined by the plan rules. Company contributions are in accordance with the requirements of the Government of Canada legislation, the Pension Benefits Standards Act, 1985, including amendments and regulations thereto, and such contributions follow minimum 70 CN | 2015 Annual Report and maximum thresholds as determined by actuarial valuations. Actuarial valuations are generally required on an annual basis for all Canadian plans, or when deemed appropriate by the Office of the Superintendent of Financial Institutions. These actuarial valuations are prepared in accordance with legislative requirements and with the recommendations of the Canadian Institute of Actuaries for the valuation of pension plans. Actuarial valuations are also required annually for the Company’s U.S. qualified pension plans. The Company’s most recently filed actuarial valuations for its Canadian registered pension plans conducted as at December 31, 2014 indicated a funding excess on a going concern basis of approximately $1.9 billion and a funding deficit on a solvency basis of approximately $0.7 billion, calculated using the three-year average of the plans’ hypothetical wind-up ratio in accordance with the Pension Benefit Standards Regulations, 1985. The federal pension legislation requires funding deficits, as calculated under current pension regulations, to be paid over a number of years. Alternatively, a letter of credit can be subscribed to fulfill required solvency deficit payments. The Company’s next actuarial valuations for its Canadian plans required as at December 31, 2015 will be performed in 2016. These actuarial valuations are expected to identify a funding excess on a going concern basis of approximately $2.3 billion, while on a solvency basis a funding excess of approximately $0.2 billion is expected. Based on the anticipated results of these valuations, the Company expects to make total cash contributions of approximately $115 million for all pension plans in 2016. As at February 1, 2016 the Company had contributed $60 million to its defined benefit pension plans for 2016. Plan assets The assets of the Company’s various Canadian defined benefit pension plans are primarily held in separate trust funds (“Trusts”) which are diversified by asset type, country and investment strat- egies. Each year, the CN Board of Directors reviews and confirms or amends the Statement of Investment Policies and Procedures (SIPP) which includes the plans’ long-term asset mix target and related benchmark indices (“Policy”). This Policy is based on a long-term forward-looking view of the world economy, the dynamics of the plans’ benefit obligations, the market return expectations of each asset class and the current state of financial markets. Annually, the CN Investment Division (“Investment Manager”), a division of the Company created to invest and administer the assets of the plans, proposes a short-term asset mix target (“Strategy”) for the coming year, which is expected to differ from the Policy, because of current economic and market conditions and expect- ations. The Investment Committee of the Board (“Committee”) regularly compares the actual asset mix to the Policy and Strategy and compares the actual performance of the Company’s pension plans to the performance of the benchmark indices. Notes to Consolidated Financial Statements The Company’s 2015 Policy and actual asset allocation for the • Absolute return investments are primarily a portfolio of units Company’s pension plans based on fair value are as follows: of externally managed hedge funds, which are invested in Cash and short-term investments Bonds and mortgages Equities Real estate Oil and gas Infrastructure Absolute return Risk-based allocation Total Actual plan asset allocation 2014 2015 2% 30% 40% 2% 5% 7% 11% 3% 3% 29% 39% 2% 8% 5% 10% 4% Policy 3% 37% 45% 4% 7% 4% - - 100% 100% 100% various long/short strategies within multi-strategy, fixed income, equities, global macro and commodity funds, as presented in the table of fair value measurement. Managers are monitored on a continuous basis through investment and operational due diligence. • Risk-based allocation investments are a portfolio of units of externally managed funds where the asset class exposures are managed on a risk-adjusted basis in order to capture asset class premiums. The plans’ Investment Manager monitors market events and exposures to markets, currencies and interest rates daily. When investing in foreign securities, the plans are exposed to foreign The Committee’s approval is required for all major investments in currency risk that may be adjusted or hedged; the effect of which illiquid securities. The SIPP allows for the use of derivative financial is included in the valuation of the foreign securities. Net of the instruments to implement strategies, hedge, and adjust existing or effects mentioned above, the plans were 66% exposed to the anticipated exposures. The SIPP prohibits investments in securities of Canadian dollar, 13% to the US dollar, 8% to European currencies, the Company or its subsidiaries. Investments held in the Company’s 5% to the Japanese Yen and 8% to various other currencies as at pension plans consist mainly of the following: December 31, 2015. Interest rate risk represents the risk that the • Cash and short-term investments consist primarily of highly fair value of the investments will fluctuate due to changes in market liquid securities which ensure adequate cash flows are available interest rates. Sensitivity to interest rates is a function of the timing to cover near-term benefit payments. Short-term investments are and amount of cash flows of the assets and liabilities of the plans. mainly obligations issued by Canadian chartered banks. Overall return in the capital markets and the level of interest rates • Bonds include bond instruments, issued or guaranteed by affect the funded status of the Company’s pension plans, particu- governments and corporate entities, as well as corporate notes larly the Company’s main Canadian pension plan. Adverse changes and investments in emerging market debt. As at December 31, with respect to pension plan returns and the level of interest rates 2015, 74% (82% in 2014) of bonds were issued or guaranteed from the date of the last actuarial valuations may have a material by Canadian, U.S. or other governments. Mortgages consist adverse effect on the funded status of the plans and on the of mortgage products which are primarily conventional or Company’s results of operations. Derivatives are used from time to participating loans secured by commercial properties. time to adjust asset mix or exposures to foreign currencies, interest • Equity investments are primarily publicly traded securities, rate or market risks of the portfolio or anticipated transactions. well diversified by country, issuer and industry sector. As at Derivatives are contractual agreements whose value is derived from December 31, 2015, the most significant allocation to an indi- interest rates, foreign exchange rates, and equity or commodity vidual issuer was approximately 2% (2% in 2014) and the most prices. They may include forwards, futures, options and swaps and significant allocation to an industry sector was approximately are included in investment categories based on their underlying 22% (23% in 2014). exposure. When derivatives are used for hedging purposes, the • Real estate is a diversified portfolio of Canadian land and com- gains or losses on the derivatives are offset by a corresponding mercial properties and investments in real estate private equity change in the value of the hedged assets. To manage credit risk, funds. established policies require dealing with counterparties considered • Oil and gas investments include petroleum and natural gas to be of high credit quality. properties and listed and non-listed Canadian securities of oil The tables on the following pages present the fair value of plan and gas companies. assets as at December 31, 2015 and 2014 by asset class, their level • Infrastructure investments include participations in private within the fair value hierarchy, and the valuation techniques and infrastructure funds, public and private debt and publicly traded inputs used to measure such fair value: equity securities of infrastructure and utility companies. CN | 2015 Annual Report 71 Notes to Consolidated Financial Statements 12 | Pensions and other postretirement benefits continued In millions Cash and short-term investments (1) Bonds (2) Canada, U.S. and supranational Provinces of Canada and municipalities Corporate Emerging market debt Mortgages (3) Equities (4) Canadian U.S. International Real estate (5) Oil and gas (6) Infrastructure (7) Absolute return funds (8) Multi-strategy Fixed income Equity Global macro Risk-based allocation (9) Total Other (10) Total plan assets In millions Cash and short-term investments (1) Bonds (2) Canada, U.S. and supranational Provinces of Canada and municipalities Corporate Emerging market debt Mortgages (3) Equities (4) Canadian U.S. International Real estate (5) Oil and gas (6) Infrastructure (7) Absolute return funds (8) Multi-strategy Fixed income Equity Global macro Commodity Risk-based allocation (9) Total Other (10) Total plan assets Fair value measurements at December 31, 2015 Total Level 1 Level 2 Level 3 $ 389 $ 47 $ 342 $ 1,280 2,611 911 471 127 1,556 1,236 4,315 357 1,012 1,237 714 440 261 499 422 - - - - - 1,532 1,236 4,315 - 234 10 - - - - - 1,280 2,611 911 471 127 - - - - 12 102 714 372 261 499 422 - - - - - - 24 - - 357 766 1,125 - 68 - - - $ 17,838 $ 7,374 $ 8,124 $ 2,340 79 $ 17,917 Fair value measurements at December 31, 2014 Total Level 1 Level 2 Level 3 $ 579 $ 64 $ 515 $ 1,450 2,701 618 296 131 2,096 1,493 3,425 317 1,374 885 591 471 299 384 1 635 - - - - - 2,072 1,493 3,425 - 349 14 - - - - - - 1,450 2,701 618 296 131 - - - - 17 107 591 428 299 384 1 635 - - - - - - 24 - - 317 1,008 764 - 43 - - - - $ 17,746 $ 7,417 $ 8,173 $ 2,156 15 $ 17,761 Level 1: Fair value based on quoted prices in active markets for identical assets. Level 2: Fair value based on other significant observable inputs. Level 3: Fair value based on significant unobservable inputs. Footnotes to the table follow on the next page. 72 CN | 2015 Annual Report Notes to Consolidated Financial Statements The following table reconciles the beginning and ending balances of the fair value of investments classified as Level 3: In millions Equities (4) Real estate (5) Oil and gas (6) Infrastructure (7) return (8) Total Balance at December 31, 2013 $ 22 $ 299 $ 961 $ 663 $ 33 $ 1,978 Fair value measurements based on significant unobservable inputs (Level 3) Absolute Actual return relating to assets still held at the reporting date Purchases Sales 1 4 (3) 21 - (3) - 47 - 2 159 (60) 1 9 - 25 219 (66) Balance at December 31, 2014 $ 24 $ 317 $ 1,008 $ 764 $ 43 $ 2,156 Actual return relating to assets still held at the reporting date Purchases Sales 5 3 (8) (5) 51 (6) (242) - - 160 405 (204) 1 30 (6) (81) 489 (224) Balance at December 31, 2015 $ 24 $ 357 $ 766 $ 1,125 $ 68 $ 2,340 (1) Cash and short-term investments are valued at cost, which approximates fair value, and are categorized as Level 1 for cash and Level 2 for short-term investments. (2) Bonds are valued using mid-price bids obtained from independent pricing data suppliers. When prices are not available from independent sources, the fair value is based on the present value of future cash flows using current market yields for comparable instruments. Emerging market debt funds are valued based on the net asset value obtained from each fund’s administrator. All bonds are categorized as Level 2. (3) Mortgages are secured by real estate. The fair value of $127 million ($131 million in 2014) of mortgages categorized as Level 2 is based on the present value of future cash flows using current market yields for comparable instruments. (4) The fair value of equity investments categorized as Level 1 is based on quoted prices in active markets. The fair value of equity investments of $24 million ($24 million in 2014) categorized as Level 3 represent units in private equity funds which are valued by their independent administrators. (5) The fair value of real estate investments of $357 million ($317 million in 2014) includes land and buildings net of related mortgage debt of $4 million ($34 million in 2014) and is categorized as Level 3. Land is valued based on the fair value of comparable assets, and buildings are valued based on the present value of estimated future net cash flows or the fair value of comparable assets. Independent valuations of land and buildings are performed triennially on a rotational basis. Mortgage debt is valued based on the present value of future cash flows using current market yields for comparable instruments. (6) Oil and gas investments categorized as Level 1 are valued based on quoted prices in active markets. Investments in oil and gas equities traded on a secondary market are valued based on the most recent transaction price and are categorized as Level 2. Investments of $766 million ($1,008 million in 2014) categorized as Level 3 consist of operating oil and gas properties and the fair value is based on estimated future net cash flows that are discounted using prevailing market rates for transactions in similar assets. The future net cash flows are based on forecasted oil and gas prices and projected future annual production and costs. (7) Infrastructure investments consist of $10 million ($14 million in 2014) of publicly traded equity securities of infrastructure companies categorized as Level 1, $102 million ($107 million in 2014) of term loans, bonds and infrastructure funds issued by infrastructure companies categorized as Level 2 and $1,125 million ($764 million in 2014) of infrastructure funds that are categorized as Level 3 and are valued based on discounted cash flows or earnings multiples. Distributions may be received throughout the term of the funds and/or upon the sale of the underlying investments. (8) Absolute return investments are valued using the net asset value as reported by the independent fund administrators. All absolute return investments have contractual redemption frequencies, ranging from monthly to annually, and redemption notice periods varying from 5 to 90 days. Absolute return investments are categorized as Level 2 except those that have redemption dates less frequent than every four months or that have restrictions on contractual redemption features at the reporting date, which are categorized as Level 3. (9) Risk-based allocation investments are valued using the net asset value as reported by the independent fund administrators and are categorized as Level 2. All funds have contractual redemption frequencies ranging from daily to annually, and redemption notice periods varying from 5 to 60 days. (10) Other consists of operating assets of $119 million ($145 million in 2014) and liabilities of $40 million ($130 million in 2014) required to administer the Trusts’ investment assets and the plans’ benefit and funding activities. Such assets are valued at cost and have not been assigned to a fair value category. CN | 2015 Annual Report 73 Notes to Consolidated Financial Statements 12 | Pensions and other postretirement benefits continued Obligations and funded status for defined benefit pension and other postretirement benefit plans In millions Year ended December 31, 2015 2014 Pensions Other postretirement benefits 2014 2015 Change in benefit obligation Projected benefit obligation at beginning of year $ 17,279 $ 15,510 $ 267 $ 256 Amendments Interest cost Actuarial loss (gain) on projected benefit obligation Service cost Plan participants’ contributions Foreign currency changes Benefit payments, settlements and transfers Projected benefit obligation at end of year (1) Component representing future salary increases Accumulated benefit obligation at end of year Change in plan assets 1 650 (112) 152 58 55 2 711 1,815 132 58 22 (1,002) (971) - 10 (8) 3 - 14 (17) 2 12 6 2 - 7 (18) $ 17,081 $ 17,279 $ 269 $ 267 (334) (349) - - $ 16,747 $ 16,930 $ 269 $ 267 Fair value of plan assets at beginning of year $ 17,761 $ 16,869 Employer contributions Plan participants’ contributions Foreign currency changes Actual return on plan assets Benefit payments, settlements and transfers Fair value of plan assets at end of year (1) Funded status - Excess (deficiency) of fair value of plan assets over projected benefit obligation at end of year 108 58 34 958 (1,002) 111 58 15 1,679 (971) $ 17,917 $ 17,761 $ $ - - - - - - - $ $ - - - - - - - $ 836 $ 482 $ (269) $ (267) (1) The projected benefit obligation and fair value of plan assets for the CN Pension Plan at December 31, 2015 were $15,794 million and $17,038 million, respectively ($16,059 million and $16,905 million, respectively, at December 31, 2014). The measurement date of all plans is December 31. Amounts recognized in the Consolidated Balance Sheets In millions Noncurrent assets - Pension asset Current liabilities (Note 9) Noncurrent liabilities - Pension and other postretirement benefits Total amount recognized December 31, 2015 2014 Pensions Other postretirement benefits 2014 2015 $ 1,305 $ 882 $ - $ - - (469) - (400) (18) (251) (17) (250) $ 836 $ 482 $ (269) $ (267) Amounts recognized in Accumulated other comprehensive loss (Note 15) In millions Net actuarial gain (loss) (1) Prior service cost (2) December 31, 2015 2014 Pensions Other postretirement benefits 2014 2015 $ (2,204) $ (2,502) (17) (20) $ $ 21 (4) 17 (5) (1) The estimated net actuarial loss for defined benefit pension plans and net actuarial gain for other postretirement benefits that will be amortized from Accumulated other comprehensive loss into net periodic benefit cost (income) over the next fiscal year are $198 million and $6 million, respectively. (2) The estimated prior service cost for defined benefit pension plans and other postretirement benefits that will be amortized from Accumulated other comprehensive loss into net periodic benefit cost (income) over the next fiscal year are $4 million and $1 million, respectively. 74 CN | 2015 Annual Report Notes to Consolidated Financial Statements Information for the pension plans with an accumulated benefit obligation in excess of plan assets In millions Projected benefit obligation Accumulated benefit obligation Fair value of plan assets December 31, 2015 2014 Pensions Other postretirement benefits 2014 2015 $ 743 $ 646 656 274 585 246 N/A N/A N/A N/A N/A N/A Components of net periodic benefit cost (income) for defined benefit pension and other postretirement benefit plans In millions Current service cost Interest cost Settlement loss Expected return on plan assets Amortization of prior service cost Amortization of net actuarial loss (gain) Net periodic benefit cost (income) Year ended December 31, 2015 Pensions 2014 2013 Other postretirement benefits 2013 2014 2015 $ 152 $ 132 $ 155 $ 650 4 (1,004) 4 228 711 3 (978) 4 124 658 4 (958) 4 227 $ 34 $ (4) $ 90 $ 3 10 - - 1 (4) 10 $ $ 2 12 - - 2 (4) 12 $ $ 3 11 - - 1 (1) 14 Weighted-average assumptions used in accounting for defined benefit pension and other postretirement benefit plans December 31, 2015 Pensions 2014 2013 Other postretirement benefits 2013 2014 2015 To determine projected benefit obligation Discount rate (1) (2) Rate of compensation increase (3) To determine net periodic benefit cost Discount rate (1) Rate of compensation increase (3) Expected return on plan assets (4) 3.99% 3.87% 4.73% 4.14% 3.86% 4.69% 2.75% 3.00% 3.00% 2.75% 3.00% 3.00% 3.87% 4.73% 4.15% 3.86% 4.69% 4.01% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 7.00% 7.00% 7.00% N/A N/A N/A (1) The Company’s discount rate assumption, which is set annually at the end of each year, is used to determine the projected benefit obligation at the end of the year and the net periodic benefit cost for the following year. Beginning in 2016, as described in the “Adoption of the spot rate approach” section of this Note, the Company will adopt the spot rate approach to measure current service cost and interest cost for all defined benefit pension and other postretirement benefit plans. (2) The discount rate is used to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments with a rating of AA or better, would provide the necessary cash flows to pay for pension benefits as they become due. The discount rate is determined by management with the aid of third-party actuaries. For the Canadian pension and other postretirement benefit plans, future expected benefit payments at each measurement date are discounted using spot rates from a derived AA corporate bond yield curve. The derived curve is based on observed rates for AA corporate bonds with short-term maturities and a projected AA corporate curve for longer-term maturities based on spreads between observed AA corporate bonds and AA provincial bonds. The derived curve is expected to generate cash flows that match the estimated future benefit payments of the plans as the bond rate for each maturity year is applied to the plans’ corresponding expected benefit payments of that year. (3) The rate of compensation increase is determined by the Company based upon its long-term plans for such increases. (4) To develop its expected long-term rate of return assumption used in the calculation of net periodic benefit cost applicable to the market-related value of assets, the Company considers multiple factors. The expected long-term rate of return is determined based on expected future performance for each asset class and is weighted based on the current asset portfolio mix. Consideration is taken of the historical performance, the premium return generated from an actively managed portfolio, as well as current and future anticipated asset allocations, economic developments, inflation rates and administrative expenses. Based on these factors, the rate is determined by the Company. For 2015, the Company used a long-term rate of return assumption of 7.00% on the market-related value of plan assets to compute net periodic benefit cost (income). The Company has elected to use a market-related value of assets, whereby realized and unrealized gains/ losses and appreciation/depreciation in the value of the investments are recognized over a period of five years, while investment income is recognized immediately. In 2016, the Company will maintain the expected long-term rate of return on plan assets at 7.00% to reflect management’s current view of long-term investment returns. CN | 2015 Annual Report 75 Notes to Consolidated Financial Statements 12 | Pensions and other postretirement benefits continued Adoption of the spot rate approach Beginning in 2016, the Company will adopt the spot rate approach to measure current service cost and interest cost for all defined bene- Health care cost trend rate for other postretirement benefits fit pension and other postretirement benefit plans on a prospective For measurement purposes, increases in the per capita cost of basis as a change in accounting estimate. In 2015 and in prior years, covered health care benefits were assumed to be 6.5% for 2015. these costs were determined using the discount rate used to meas- It is assumed that the rate will decrease gradually to 4.5% in 2028 ure the projected benefit obligation at the beginning of the period. and remain at that level thereafter. Assumed health care costs have an effect on the amounts reported for health care plans. A The spot rate approach enhances the precision to which current service cost and interest cost are measured by increasing the one-percentage-point change in the assumed health care cost trend correlation between projected cash flows and spot discount rates corresponding to their maturity. Under the spot rate approach, individual spot discount rates along the same yield curve used in the determination of the projected benefit obligation are applied to the relevant projected cash flows at the relevant maturity. More specific- ally, current service cost is measured using the projected cash flows related to benefits expected to be accrued in the following year by active members of a plan and interest cost is measured using the projected cash flows making up the projected benefit obligation multiplied by the corresponding spot discount rate at each maturity. Use of the spot rate approach does not affect the measurement of the projected benefit obligation. Based on bond yields prevailing at December 31, 2015, the single equivalent discount rates to determine current service cost and interest cost under the spot rate approach in 2016 are 4.24% and 3.27%, respectively, compared to 3.99%, for both costs, under the approach applicable to 2015 and prior years. For 2016, the Company estimates the adoption of the spot rate approach will increase net periodic benefit income by approximately $120 million compared to the approach applicable in 2015 and prior years. rate would have the following effect: In millions One-percentage-point Increase Decrease Effect on total service and interest costs $ Effect on benefit obligation 1 13 $ (1) (11) Estimated future benefit payments In millions 2016 2017 2018 2019 2020 Years 2021 to 2025 Other postretirement benefits $ 18 19 19 18 18 87 Pensions $ 1,029 1,040 1,048 1,053 1,059 5,276 Defined contribution and other plans The Company maintains defined contribution pension plans for certain salaried employees as well as certain employees covered by collective bargaining agreements. The Company also maintains other plans including Section 401(k) savings plans for certain U.S. based employees. The Company’s contributions under these plans are expensed as incurred and amounted to $18 million, $16 million and $13 million for 2015, 2014 and 2013, respectively. Contributions to multi-employer plan Under collective bargaining agreements, the Company participates in a multi-employer benefit plan named the Railroad Employees National Early Retirement Major Medical Benefit Plan which is administered by the National Carriers’ Conference Committee (NCCC), and provides certain postretirement health care benefits to certain retirees. For 2015, 2014 and 2013, the Company’s contri- butions under this plan were expensed as incurred and amounted to $10 million in each year. The annual contribution rate for the plan is determined by the NCCC and was $140.54 per month per active employee for 2015 ($141.29 in 2014). The plan covered 777 retirees in 2015 (807 in 2014). 76 CN | 2015 Annual Report Notes to Consolidated Financial Statements 13 | Share capital Authorized capital stock The authorized capital stock of the Company is as follows: • Unlimited number of Common Shares, without par value • Unlimited number of Class A Preferred Shares, without par value, issuable in series • Unlimited number of Class B Preferred Shares, without par value, issuable in series Common shares In millions December 31, 2015 2014 2013 Share purchases by Share Trusts In 2014, the Company established Share Trusts to purchase common shares on the open market, which will be used to deliver common shares under the Share Units Plan (see Note 14 – Stock- based compensation). Shares purchased by the Share Trusts are retained until the Company instructs the trustee to transfer shares to participants of the Share Units Plan. Common shares purchased by the Share Trusts are accounted for as treasury stock. The Share Trusts may sell shares on the open market to facilitate the remit- tance of the Company’s employee tax withholding obligations. In 2016, the Share Trusts could purchase up to 1.2 million common shares on the open market in anticipation of future settlements of equity settled PSU awards. Issued common shares 788.6 809.4 830.6 For the year ended December 31, 2015, the Share Trusts purchased Common shares in Share Trusts (1.4) - - Outstanding common shares 787.2 809.4 830.6 1.4 million common shares for $100 million at a weighted- average price per share of $73.31, including brokerage fees. Share purchases Share repurchase programs Additional paid-in capital Additional paid-in capital includes the stock-based compensation The Company may repurchase shares pursuant to a normal course expense on equity settled awards; the excess tax benefits on stock- issuer bid (NCIB) at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. Under its current NCIB, the Company may repurchase up to 33.0 million common shares between October 30, 2015 and October 29, 2016. As at December 31, 2015, the Company based compensation; and other items relating to equity settled awards. It also includes the impact of the modification of certain cash settled awards to equity settled awards, which represents the fair value of cash settled stock-based compensation awards modified in 2014 to settle in common shares of the Company and repurchased 5.8 million common shares under its current program. consists of $132 million, $60 million and $17 million related DSUs, The following table provides the information related to the share PSUs and other plans, respectively (see Note 14 – Stock-based repurchase programs for the years ended December 31, 2015, 2014 compensation). Upon the exercise or settlement of equity settled and 2013: In millions, except per share data Year ended December 31, 2015 2014 2013 Number of common shares repurchased (1) 23.3 22.4 27.6 Weighted-average price per share (2) $ 75.20 $ 67.38 $ 50.65 Amount of repurchase (3) $ 1,750 $ 1,505 $ 1,400 (1) Includes common shares repurchased in the first, third and fourth quarters of 2015, and the first and fourth quarters of 2014 and 2013 pursuant to private agreements between the Company and arm’s-length third-party sellers. (2) Includes brokerage fees. (3) The 2015 common share repurchases include settlements in the subsequent period. awards, the stock-based compensation expense related to those awards is reclassified from Additional paid-in capital to Common shares. The Company reclassified prior year balances from Common shares to Additional paid-in capital in the Consolidated Statement of Shareholders’ Equity to conform with the 2015 presentation. CN | 2015 Annual Report 77 Notes to Consolidated Financial Statements 14 | Stock-based compensation The Company has various stock-based compensation plans for eligible employees. A description of the major plans is provided herein. The following table provides the stock-based compensation expense for awards under all plans, as well as the related tax benefit recognized in income, for the years ended December 31, 2015, 2014 and 2013: In millions Share Units Plan Equity settled awards Cash settled awards Total Share Units Plan expense Voluntary Incentive Deferral Plan (VIDP) Cash settled awards Total VIDP expense (recovery) Stock option awards Total stock-based compensation expense Tax benefit recognized in income Year ended December 31, 2015 2014 2013 $ $ $ $ $ $ $ 39 14 53 (3) (3) 11 61 14 $ 2 117 $ 119 $ $ $ 33 33 9 $ 161 $ 43 $ $ $ $ $ - 92 92 35 35 9 $ 136 $ 35 Share Units Plan the participant upon settlement is equal to the number of PSUs The objective of the Share Units Plan is to enhance the Company’s awarded multiplied by the performance vesting factor less shares ability to attract and retain talented employees and to provide align- withheld to satisfy the participant’s minimum statutory withholding ment of interests between such employees and the shareholders tax requirement. For the plan period ended December 31, 2015, of the Company. Under the Share Units Plan, the Company grants for the 2013 grant, the level of ROIC attained resulted in a performance share unit (PSU) awards. performance vesting factor of 150%. The total fair value of the The PSU-ROIC awards vest dependent upon the attainment of equity settled awards that were vested in 2015 was $48 million. a target relating to return on invested capital (ROIC) over the plan As the minimum share price condition under the plan was met, period of three years. Such performance vesting criteria results in settlement of approximately 0.6 million shares from the Share a performance vesting factor that ranges from 0% to 200% for Trusts is expected to occur in the first quarter of 2016. PSU-ROIC awards granted in 2015 (0% to 150% for PSUs-ROIC outstanding and granted prior to December 31, 2014) depending Cash settled awards on the level of ROIC attained. Payout is conditional upon the The value of the payout is equal to the number of PSUs-ROIC attainment of a minimum share price, calculated using the average awarded multiplied by the performance vesting factor and by the of the last three months of the plan period. 20-day average closing share price ending on January 31 of the PSU-TSR awards, introduced in 2015, vest from 0% to 200%, following year. For the plan period ended December 31, 2015, for subject to the attainment of a total shareholder return (TSR) the 2013 grant, the level of ROIC attained resulted in a perform- market condition over the plan period of three years based on the Company’s TSR relative to a Class I Railways peer group and components of the S&P/TSX 60 Index. ance vesting factor of 150%. The total fair value of the cash settled awards that were vested in 2015 was $39 million ($106 million in 2014 and $80 million in 2013). As the minimum share price condi- On December 9, 2014, 0.5 million cash settled PSUs-ROIC tion under the plan was met, payout of approximately $39 million granted in 2013 and 0.4 million cash settled PSUs-ROIC granted is expected to be paid in the first quarter of 2016. in 2014 were modified to equity settled awards. The modification In 2015, there were no cash settled PSU-ROIC awards granted. affected PSUs-ROIC held by 133 employees and did not result in the In 2014, the Company granted 0.8 million PSU-ROIC awards recognition of incremental compensation cost as the awards were (0.8 million in 2013) to designated management employees previously recognized at fair value. Further, there was no change to entitling them to receive payout in cash based on the Company’s the vesting conditions of the awards. Equity settled awards share price. These awards were then subject to modification resulting in 0.4 million PSU-ROIC awards granted in 2014 (0.5 million in 2013) to be settled in common shares of the PSUs-ROIC and PSUs-TSR are settled in common shares of the Company. Company, subject to the attainment of their respective vesting conditions, by way of disbursement from the Share Trusts (see Note 13 – Share capital). The number of shares remitted to 78 CN | 2015 Annual Report Notes to Consolidated Financial Statements The following table provides a summary of the activity related to PSU awards: Equity settled PSUs-ROIC (1) PSUs-TSR (2) Cash settled PSUs-ROIC (3) Weighted- average grant date fair value $ 71.05 $ 50.87 N/A $ 64.36 $ 71.05 $ 50.87 $ 75.15 $ 58.83 Units In millions 0.9 0.4 - 1.3 0.9 0.4 (0.5) 0.8 Weighted- average grant date fair value Units In millions - N/A 0.1 $ 114.86 - N/A 0.1 $ 114.86 - N/A 0.1 $ 114.86 - N/A 0.1 $ 114.86 Units In millions 1.6 - (0.9) 0.7 0.7 - (0.3) 0.4 Outstanding at December 31, 2014 Granted Settled Outstanding at December 31, 2015 Nonvested at December 31, 2014 Granted Vested during the year (4) Nonvested at December 31, 2015 (1) The grant date fair value of equity settled PSUs-ROIC granted in 2015 of $22 million is calculated using a lattice-based valuation model. As at December 31, 2015, total unrecognized compensation cost related to nonvested equity settled PSUs-ROIC outstanding was $20 million and is expected to be recognized over a weighted-average period of 1.6 years. (2) The grant date fair value of equity settled PSUs-TSR granted in 2015 of $16 million is calculated using a Monte Carlo simulation model. As at December 31, 2015, total unrecognized compensation cost related to non-vested equity settled PSUs-TSR outstanding was $7 million and is expected to be recognized over a weighted-average period of 1.8 years. (3) The fair value at December 31, 2015 of cash settled PSUs-ROIC is calculated using a lattice-based valuation model. As at December 31, 2015, total unrecognized compensation cost related to nonvested cash settled PSUs-ROIC outstanding was $8 million and is expected to be recognized over a weighted-average period of 1.0 years. (4) The awards that were vested during the year are expected to be settled in the first quarter of 2016. The following table provides the assumptions and fair values related to the PSU-ROIC awards: Year of grant Assumptions Stock price ($) (3) Expected stock price volatility (4) Expected term (years) (5) Risk-free interest rate (6) Dividend rate ($) (7) Equity settled PSUs-ROIC (1) 2014 2015 2013 2015 84.55 15% 3.0 76.29 15% 2.0 76.29 17% 1.0 0.45% 1.02% 0.98% 1.25 1.00 1.00 Cash settled PSUs-ROIC (2) 2014 2013 77.35 77.35 23% 1.0 0.49% 1.25 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Weighted-average grant date fair value ($) 50.87 66.84 75.15 Fair value per unit ($) N/A N/A N/A N/A 66.45 77.35 (1) Assumptions used to determine fair value of the equity settled PSU-ROIC awards are on the grant date. (2) Assumptions used to determine fair value of the cash settled PSU-ROIC awards are as at December 31, 2015. (3) For equity settled awards, the stock price represents the closing share price on the grant date. The stock price on the grant date for 2014 and 2013 is the stock price at the modification date of December 9, 2014. (4) Based on the historical volatility of the Company’s stock over a period commensurate with the expected term of the award. (5) Represents the period of time that awards are expected to be outstanding. (6) Based on the implied yield available on zero-coupon government issues with an equivalent term commensurate with the expected term of the awards. (7) Based on the annualized dividend rate. CN | 2015 Annual Report 79 Notes to Consolidated Financial Statements 14 | Stock-based compensation continued Voluntary Incentive Deferral Plan On December 9, 2014, 1.7 million cash settled DSUs were modified to equity settled awards. The modification affected DSUs held by 104 employees and did not result in the recognition of incremental compensation cost as the awards were previously The Company’s Voluntary Incentive Deferral Plan (VIDP) provides recognized at fair value. Further, there was no change to the vesting eligible senior management employees the opportunity to elect to conditions of the awards. receive their annual incentive bonus payment and other eligible incentive payments in deferred share units (DSU) of the Company Equity settled awards up to specific deferral limits. A DSU is equivalent to a common DSUs are settled in common shares of the Company at the time of share of the Company and also earns dividends when normal cash cessation of employment by way of an open market purchase by dividends are paid on common shares. For equity settled DSUs, the the Company. The number of shares remitted to the participant is number of DSUs received by each participant is established at time equal to the number of DSUs awarded less shares withheld to satisfy of deferral. For cash settled DSUs, the number of DSUs received by the participant’s minimum statutory withholding tax requirement. each participant is calculated using the Company’s average closing The total fair value of equity settled DSU awards vested in both share price for the 20 trading days prior to and including the date 2015 and 2014 was $1 million. of the incentive payment. For each participant, the Company will grant a further 25% of the amount elected in DSUs, which will vest Cash settled awards over a period of four years. The election to receive eligible incentive The value of each participant’s DSUs is payable in cash at the time payments in DSUs is no longer available to a participant when of cessation of employment. the value of the participant’s vested DSUs is sufficient to meet the The total fair value of cash settled DSU awards vested in both Company’s stock ownership guidelines. 2015 and 2014 was nil ($1 million in 2013). The following table provides a summary of the activity related to DSU awards: Outstanding at December 31, 2014 (3) Granted Vested Settled Outstanding at December 31, 2015 (4) Equity settled DSUs (1) Cash settled DSUs (2) Weighted- average grant date fair value $ 76.29 $ 81.18 $ 77.23 $ 76.38 $ 76.44 Units In millions 1.7 - 0.1 - 1.8 Units In millions 0.5 - - (0.1) 0.4 (1) The grant date fair value of equity settled DSUs granted in 2015 of $2 million is calculated using the stock price at the grant date. As at December 31, 2015, the aggregate intrinsic value of equity settled DSUs outstanding amounted to $132 million. (2) The fair value at December 31, 2015 of cash settled DSUs is based on the intrinsic value. As at December 31, 2015 the DSU liability was $36 million ($40 million as at December 31, 2014). The closing stock price used to determine the liability was $77.35. (3) The weighted-average grant date fair value was $76.29 per unit for equity settled DSUs modified in 2014. (4) The number of units outstanding that were nonvested, unrecognized compensation cost related to cash settled DSUs and the remaining recognition period for cash and equity settled DSUs have not been quantified as they relate to a minimal number of units. 80 CN | 2015 Annual Report Notes to Consolidated Financial Statements Stock option awards first 12 months after the date of grant and expire after 10 years. The Company has stock option plans for eligible employees to As at December 31, 2015, 18.4 million common shares remained acquire common shares of the Company upon vesting at a price authorized for future issuances under these plans. equal to the market value of the common shares at the date of For 2015, 2014 and 2013, the Company granted 0.9 million, granting. The options issued by the Company are conventional 1.0 million and 1.1 million stock options, respectively. options that vest over a period of time. The right to exercise The total number of conventional options outstanding as at options generally accrues over a period of four years of continuous December 31, 2015 was 5.9 million. employment. Options are not generally exercisable during the The following table provides the activity of stock option awards during 2015, and for options outstanding and exercisable at December 31, 2015, the weighted-average exercise price: Outstanding at December 31, 2014 (1) Granted (2) Exercised (3) Vested (4) Outstanding at December 31, 2015 (1) Exercisable at December 31, 2015 (1) Options outstanding Nonvested options Number Weighted- average of options exercise price In millions 7.5 0.9 $ 37.37 $ 84.47 (2.5) $ 29.30 N/A 5.9 3.6 N/A $ 53.43 $ 41.74 Weighted- average grant date fair value $ 9.25 $ 13.21 N/A $ 8.72 $ 10.94 N/A Number of options In millions 2.5 0.9 N/A (1.1) 2.3 N/A (1) Stock options with a US dollar exercise price have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. (2) The grant date fair value of options awarded in 2015 of $11 million is calculated using the Black-Scholes option-pricing model. As at December 31, 2015, total unrecognized compensation cost related to nonvested options outstanding was $7 million and is expected to be recognized over a weighted-average period of 2.3 years. (3) The total intrinsic value of options exercised in 2015 was $127 million ($50 million in 2014 and $45 million in 2013). The cash received upon exercise of options in 2015 was $74 million ($25 million in 2014 and $28 million in 2013) and the related excess tax benefit realized was $5 million ($5 million in 2014 and $3 million in 2013). (4) The fair value of options vested in 2015 was $9 million ($9 million in 2014 and $11 million in 2013). The following table provides the number of stock options outstanding and exercisable as at December 31, 2015 by range of exercise price and their related intrinsic value, and for options outstanding, the weighted-average years to expiration. The table also provides the aggregate intrinsic value for in-the-money stock options, which represents the value that would have been received by option holders had they exercised their options on December 31, 2015 at the Company’s closing stock price of $77.35. Range of exercise prices $20.95 - $31.09 $31.10 - $47.85 $47.86 - $58.71 $58.72 - $80.87 $80.88 - $95.62 Balance at December 31, 2015 (1) of options In millions 0.9 1.4 1.5 1.2 0.9 5.9 Options outstanding Weighted- Number average years Weighted- average to expiration exercise price Aggregate intrinsic value In millions $ 48 56 37 10 - $ 151 Options exercisable Number Weighted- average of options exercise price In millions Aggregate intrinsic value In millions 0.9 1.2 1.1 0.4 - 3.6 $ 24.54 $ 36.75 $ 50.81 $ 68.09 $ 95.62 $ 41.74 $ 48 47 28 4 - $ 127 2.8 5.0 6.2 7.6 9.1 6.1 $ 24.54 $ 38.13 $ 52.48 $ 69.46 $ 89.63 $ 53.43 (1) Stock options with a US dollar exercise price have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. As at December 31, 2015, the vast majority of stock options outstanding were in-the-money. The weighted-average years to expiration of exercisable stock options was 4.8 years. CN | 2015 Annual Report 81 Notes to Consolidated Financial Statements 14 | Stock-based compensation continued The following table provides the assumptions used in the valuation of stock option awards: Year of grant Assumptions Grant price ($) Expected stock price volatility (1) Expected term (years) (2) Risk-free interest rate (3) Dividend rate ($) (4) Weighted-average grant date fair value ($) 2015 2014 2013 84.47 58.74 20% 5.5 23% 5.4 47.47 23% 5.4 0.78% 1.51% 1.41% 1.25 1.00 13.21 11.09 0.86 8.52 (1) Based on the historical volatility of the Company’s stock over a period commensurate with the expected term of the award. (2) Represents the period of time that awards are expected to be outstanding. The Company uses historical data to predict option exercise behavior. (3) Based on the implied yield available on zero-coupon government issues with an equivalent term commensurate with the expected term of the awards. (4) Based on the annualized dividend rate. Stock price volatility Employee Share Investment Plan Compensation cost for the Company’s cash settled Share Units Plan The Company has an Employee Share Investment Plan (ESIP) giving is based on the fair value of the awards at each period-end using eligible employees the opportunity to subscribe for up to 10% of the lattice-based valuation model for which a primary assumption their gross salaries to purchase shares of the Company’s common is the Company’s share price. In addition, the Company’s liability for stock on the open market and to have the Company invest, on the the cash settled VIDP is marked-to-market at each period-end and, employees’ behalf, a further 35% of the amount invested by the as such, is also reliant on the Company’s share price. Fluctuations employees, up to 6% of their gross salaries. in the Company’s share price cause volatility to stock-based The following table provides the number of participants holding compensation expense as recorded in Net income. The Company shares, the total number of ESIP shares purchased on behalf of does not currently hold any derivative financial instruments to employees, including the Company’s contributions, as well as the manage this exposure. A $1 change in the Company’s share price resulting expense recorded for the years ended December 31, 2015, at December 31, 2015 would have an impact of approximately 2014 and 2013: $2 million on stock-based compensation expense. Year ended December 31, 2015 2014 2013 Number of participants holding shares 19,728 18,488 18,488 Total number of ESIP shares purchased on behalf of employees (millions) Expense for Company contribution (millions) 2.0 $ 38 2.1 $ 34 2.3 $ 30 82 CN | 2015 Annual Report Notes to Consolidated Financial Statements 15 | Accumulated other comprehensive loss In millions Foreign currency Pension and other translation postretirement benefit plans adjustments Derivative instruments Total before tax Income tax recovery (expense) Total net of tax Balance at December 31, 2012 $ (579) $ (3,290) $ 8 $ (3,861) $ 604 $ (3,257) Other comprehensive income (loss) before reclassifications: Foreign exchange gain on translation of net investment in foreign operations Foreign exchange loss on translation of US dollar-denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries 440 (394) 440 7 447 (394) 52 (342) Actuarial gain arising during the year 1,540 (1) 1,540 (411) (1) 1,129 Amounts reclassified from Accumulated other comprehensive loss: Amortization of net actuarial loss Amortization of prior service costs Settlement loss arising during the year Other comprehensive income (loss) Balance at December 31, 2013 Other comprehensive income (loss) before reclassifications: Foreign exchange gain on translation of net investment in foreign operations Foreign exchange loss on translation of US dollar-denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries Actuarial loss arising during the year Prior service cost from plan amendment arising during the year Amounts reclassified from Accumulated other comprehensive loss: Amortization of net actuarial loss Amortization of prior service costs Settlement loss arising during the year Amortization of gain on treasury lock Other comprehensive income (loss) Balance at December 31, 2014 Other comprehensive income (loss) before reclassifications: Foreign exchange gain on translation of net investment in foreign operations Foreign exchange loss on translation of US dollar-denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries Actuarial gain arising during the year Prior service cost from plan amendment arising during the year Amounts reclassified from Accumulated other comprehensive loss: Amortization of net actuarial loss Amortization of prior service costs Settlement loss arising during the year Other comprehensive income Balance at December 31, 2015 226 5 4 (1) 226 (2) 5 (2) 4 (2) (60) (3) (1) (3) (1) (1) (3) 166 4 3 46 1,775 $ (533) $ (1,515) $ - 8 1,821 (414) 1,407 $ (2,040) $ 190 $ (1,850) 644 (569) (1,120) (1) (4) 120 6 3 (1) 75 (995) $ (458) $ (2,510) $ (1) (1) 7 1,607 (1,358) 249 74 (1) 224 5 4 306 $ (209) $ (2,204) $ 644 4 648 (569) (1,120) (4) 73 301 (1) 1 120 (2) 6 (2) 3 (2) (1) (4) (921) (32) (3) (2) (3) (1) (1) (3) - 344 (496) (819) (3) 88 4 2 (1) (577) $ (2,961) $ 534 $ (2,427) 1,607 - 1,607 (1,358) 74 (1) 181 (18) - (1,177) 56 (1) 224 (2) (56) (3) 168 5 (2) 4 (2) (1) (3) (1) (3) 4 3 555 105 660 $ (2,406) $ 639 $ (1,767) - 7 (1) Certain 2014 and 2013 balances have been reclassified to conform with the 2015 presentation. (2) Reclassified to Labor and fringe benefits on the Consolidated Statement of Income and included in components of net periodic benefit cost. See Note 12 - Pensions and other postretirement benefits. (3) Included in Income tax expense on the Consolidated Statement of Income. (4) Related to treasury lock transactions settled in prior years, which are being amortized over the terms of the related debt to Interest expense on the Consolidated Statement of Income. CN | 2015 Annual Report 83 Notes to Consolidated Financial Statements 16 | Major commitments and contingencies to ensure the interoperability with other railroads and to maintain Leases The Company has operating and capital leases, mainly for loco- motives, freight cars and intermodal equipment. Of the capital leases, many provide the option to purchase the leased items at fixed values during or at the end of the lease term. As at December 31, 2015, the Company’s commitments under these optimal operating performance. In addition, the Company has estimated remaining commit- ments, through to December 31, 2017, of approximately $48 mil- lion (US$35 million), in relation to the acquisition of the principal lines of the former Elgin, Joliet and Eastern Railway Company. These commitments are for grade separation projects, railroad infrastructure improvements, as well as commitments under a series operating and capital leases were $742 million and $640 million, of agreements with individual communities and a comprehensive respectively. Minimum rental payments for operating leases having voluntary mitigation program established to address surrounding initial non-cancelable lease terms of more than one year and municipalities’ concerns. minimum lease payments for capital leases for the next five years and thereafter, are as follows: Contingencies In millions Operating Capital 2016 2017 2018 2019 2020 2021 and thereafter Total Less: Imputed interest on capital leases at rates ranging from approximately 0.7% to 7.3% Present value of minimum lease payments included in debt (Note 10) $ 169 138 113 82 53 187 $ 742 $ 245 186 17 17 23 152 $ 640 118 $ 522 The Company also has operating lease agreements for its automotive fleet with one-year non-cancelable terms for which its practice is to renew monthly thereafter. The estimated annual rental payments for such leases are approximately $20 million and generally extend over five years. Rent expense for all operating leases was $204 million, $201 million and $179 million for the years ended December 31, 2015, 2014 and 2013, respectively. Contingent rentals and sublease rentals were not significant. Commitments As at December 31, 2015, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives, and other equip- ment and services, as well as outstanding information technology service contracts and licenses, at an aggregate cost of $1,475 mil- lion. The Company also has estimated remaining commitments of approximately $1.4 billion (US$1.0 billion), in relation to the U.S. federal government legislative requirement to implement Positive Train Control (PTC). In connection with CN’s revised PTC implemen- tation plan submitted in January 2016, CN performed a reassess- ment of all costs associated with its implementation plan and now estimates that the total implementation cost will be US$1.2 billion, of which US$0.2 billion has been spent as of December 31, 2015. The revised estimated total costs take into consideration the added complexities identified during the detailed review as well as technical challenges anticipated to comply with the regulations and 84 CN | 2015 Annual Report In the normal course of business, the Company becomes involved in various legal actions seeking compensatory and occasionally punitive damages, including actions brought on behalf of various purported classes of claimants and claims relating to employee and third-party personal injuries, occupational disease and property damage, arising out of harm to individuals or property allegedly caused by, but not limited to, derailments or other accidents. Canada Employee injuries are governed by the workers’ compensation legis- lation in each province whereby employees may be awarded either a lump sum or a future stream of payments depending on the nature and severity of the injury. As such, the provision for employ- ee injury claims is discounted. In the provinces where the Company is self-insured, costs related to employee work-related injuries are accounted for based on actuarially developed estimates of the ultimate cost associated with such injuries, including compensation, health care and third-party administration costs. A comprehensive actuarial study is generally performed at least on a triennial basis. For all other legal actions, the Company maintains, and regularly updates on a case-by-case basis, provisions for such items when the expected loss is both probable and can be reasonably estimated based on currently available information. In 2015, the Company recorded a $12 million decrease to its provision for personal injuries and other claims in Canada as a result of a comprehensive actuarial study for employee injury claims as well as various other legal claims. In 2014 and 2013, external actuarial studies resulted in a net decrease of $2 million and a net increase of $1 million, respectively. As at December 31, 2015, 2014 and 2013, the Company’s provi- sion for personal injury and other claims in Canada was as follows: In millions 2015 2014 2013 Beginning of year Accruals and other Payments End of year Current portion – End of year $ 203 $ 210 $ 209 17 (29) 28 (35) $ 191 $ 27 $ 203 $ 28 38 (37) $ 210 $ 31 Notes to Consolidated Financial Statements United States Although the Company considers such provisions to be adequate Personal injury claims by the Company’s employees, including claims for all its outstanding and pending claims, the final outcome with alleging occupational disease and work-related injuries, are subject to respect to actions outstanding or pending at December 31, 2015, the provisions of the Federal Employers’ Liability Act (FELA). Employees or with respect to future claims, cannot be reasonably determined. are compensated under FELA for damages assessed based on a finding When establishing provisions for contingent liabilities the Company of fault through the U.S. jury system or through individual settlements. considers, where a probable loss estimate cannot be made with As such, the provision is undiscounted. With limited exceptions where reasonable certainty, a range of potential probable losses for each claims are evaluated on a case-by-case basis, the Company follows an such matter, and records the amount it considers the most reasonable actuarial-based approach and accrues the expected cost for personal estimate within the range. However, when no amount within the injury, including asserted and unasserted occupational disease claims, range is a better estimate than any other amount, the minimum and property damage claims, based on actuarial estimates of their amount in the range is accrued. For matters where a loss is reason- ultimate cost. A comprehensive actuarial study is performed annually. ably possible but not probable, a range of potential losses cannot For employee work-related injuries, including asserted occupa- be estimated due to various factors which may include the limited tional disease claims, and third-party claims, including grade cross- availability of facts, the lack of demand for specific damages and the ing, trespasser and property damage claims, the actuarial valuation fact that proceedings were at an early stage. Based on information considers, among other factors, the Company’s historical patterns currently available, the Company believes that the eventual outcome of claims filings and payments. For unasserted occupational disease of the actions against the Company will not, individually or in the ag- claims, the actuarial study includes the projection of the Company’s gregate, have a material adverse effect on the Company’s consolidat- experience into the future considering the potentially exposed ed financial position. However, due to the inherent inability to predict population. The Company adjusts its liability based upon manage- with certainty unforeseeable future developments, there can be no ment’s assessment and the results of the study. On an ongoing assurance that the ultimate resolution of these actions will not have basis, management reviews and compares the assumptions inherent a material adverse effect on the Company’s results of operations, in the latest actuarial study with the current claim experience and, if financial position or liquidity in a particular quarter or fiscal year. required, adjustments to the liability are recorded. Due to the inherent uncertainty involved in projecting future Environmental matters events, including events related to occupational diseases, which include The Company’s operations are subject to numerous federal, provin- but are not limited to, the timing and number of actual claims, the cial, state, municipal and local environmental laws and regulations average cost per claim and the legislative and judicial environment, the in Canada and the U.S. concerning, among other things, emissions Company’s future payments may differ from current amounts recorded. into the air; discharges into waters; the generation, handling, In 2015, the Company recorded a $5 million reduction to its storage, transportation, treatment and disposal of waste, hazardous provision for U.S. personal injury and other claims attributable to substances, and other materials; decommissioning of underground non-occupational disease claims, third-party claims and occupational and aboveground storage tanks; and soil and groundwater contam- disease claims pursuant to the 2015 external actuarial study. In 2014 ination. A risk of environmental liability is inherent in railroad and and 2013, external actuarial studies resulted in a net decrease of related transportation operations; real estate ownership, operation $20 million and $11 million, respectively. The prior years’ decreases or control; and other commercial activities of the Company with from the 2014 and 2013 actuarial valuations were mainly attributable respect to both current and past operations. to non-occupational disease claims, third-party claims and occupational disease claims, reflecting a decrease in the Company’s estimates of un- Known existing environmental concerns asserted claims and costs related to asserted claims. The Company has The Company has identified approximately 215 sites at which an ongoing risk mitigation strategy focused on reducing the frequency it is or may be liable for remediation costs, in some cases along and severity of claims through injury prevention and containment; with other potentially responsible parties, associated with alleged mitigation of claims; and lower settlements of existing claims. contamination and is subject to environmental clean-up and As at December 31, 2015, 2014 and 2013, the Company’s provi- enforcement actions, including those imposed by the United States sion for personal injury and other claims in the U.S. was as follows: Federal Comprehensive Environmental Response, Compensation, In millions Beginning of year Accruals and other Payments Foreign exchange End of year Current portion – End of year 2015 2014 2013 and Liability Act of 1980 (CERCLA), also known as the Superfund law, or analogous state laws. CERCLA and similar state laws, in $ 95 $ 106 $ 105 addition to other similar Canadian and U.S. laws, generally impose 22 (30) 18 2 (22) 9 18 (24) 7 $ 105 $ 24 $ 95 $ 20 $ 106 $ 14 joint and several liability for clean-up and enforcement costs on current and former owners and operators of a site, as well as those whose waste is disposed of at the site, without regard to fault or the legality of the original conduct. The Company has been notified that it is a potentially responsible party for study and clean-up costs CN | 2015 Annual Report 85 Notes to Consolidated Financial Statements 16 | Major commitments and contingencies continued Unknown existing environmental concerns While the Company believes that it has identified the costs likely to be incurred for environmental matters based on known at 6 sites governed by the Superfund law (and analogous state information, the discovery of new facts, future changes in laws, the laws) for which investigation and remediation payments are or will possibility of releases of hazardous materials into the environment be made or are yet to be determined and, in many instances, is one and the Company’s ongoing efforts to identify potential environ- of several potentially responsible parties. mental liabilities that may be associated with its properties may The ultimate cost of addressing these known contaminated sites result in the identification of additional environmental liabilities and cannot be definitively established given that the estimated environ- related costs. The magnitude of such additional liabilities and the mental liability for any given site may vary depending on the nature costs of complying with future environmental laws and containing and extent of the contamination; the nature of anticipated response or remediating contamination cannot be reasonably estimated due actions, taking into account the available clean-up techniques; to many factors, including: evolving regulatory standards governing environmental liability; and • the lack of specific technical information available with respect the number of potentially responsible parties and their financial to many sites; viability. As a result, liabilities are recorded based on the results of a • the absence of any government authority, third-party orders, or four-phase assessment conducted on a site-by-site basis. A liability is claims with respect to particular sites; initially recorded when environmental assessments occur, remedial • the potential for new or changed laws and regulations and for efforts are probable, and when the costs, based on a specific plan of action in terms of the technology to be used and the extent of development of new remediation technologies and uncertainty regarding the timing of the work with respect to particular the corrective action required, can be reasonably estimated. The sites; and Company estimates the costs related to a particular site using cost • the determination of the Company’s liability in proportion to scenarios established by external consultants based on the extent of contamination and expected costs for remedial efforts. In the case of multiple parties, the Company accrues its allocable share of other potentially responsible parties and the ability to recover costs from any third parties with respect to particular sites. liability taking into account the Company’s alleged responsibility, Therefore, the likelihood of any such costs being incurred or whether the number of potentially responsible parties and their ability to pay such costs would be material to the Company cannot be determined at their respective share of the liability. Adjustments to initial estimates this time. There can thus be no assurance that liabilities or costs related are recorded as additional information becomes available. The Company’s provision for specific environmental sites is to environmental matters will not be incurred in the future, or will not have a material adverse effect on the Company’s financial position or undiscounted and includes costs for remediation and restoration of results of operations in a particular quarter or fiscal year, or that the sites, as well as monitoring costs. Environmental expenses, which Company’s liquidity will not be adversely impacted by such liabilities or are classified as Casualty and other in the Consolidated Statement costs, although management believes, based on current information, of Income, include amounts for newly identified sites or contam- inants as well as adjustments to initial estimates. Recoveries of that the costs to address environmental matters will not have a material adverse effect on the Company’s financial position or liquidity. Costs re- environmental remediation costs from other parties are recorded as lated to any unknown existing or future contamination will be accrued assets when their receipt is deemed probable. As at December 31, 2015, 2014 and 2013, the Company’s in the period in which they become probable and reasonably estimable. provision for specific environmental sites was as follows: Future occurrences In millions Beginning of year Accruals and other Payments Foreign exchange End of year Current portion - End of year 2015 2014 2013 In railroad and related transportation operations, it is possible that derailments or other accidents, including spills and releases of haz- $ 114 $ 119 $ 123 ardous materials, may occur that could cause harm to human health 81 (91) 6 11 (19) 3 12 (18) 2 $ 110 $ 51 $ 114 $ 45 $ 119 $ 41 or to the environment. As a result, the Company may incur costs in the future, which may be material, to address any such harm, compliance with laws and other risks, including costs relating to the performance of clean-ups, payment of environmental penalties and remediation obligations, and damages relating to harm to individ- uals or property. The Company anticipates that the majority of the liability at December 31, 2015 will be paid out over the next five years. However, some costs may be paid out over a longer period. Based on the information currently available, the Company considers its provisions to be adequate. 86 CN | 2015 Annual Report Notes to Consolidated Financial Statements Regulatory compliance Other guarantees The Company may incur significant capital and operating costs As at December 31, 2015, the Company, including certain of associated with environmental regulatory compliance and clean-up its subsidiaries, had granted $551 million ($487 million as at requirements, in its railroad operations and relating to its past and December 31, 2014) of irrevocable standby letters of credit and present ownership, operation or control of real property. Operating $120 million ($106 million as at December 31, 2014) of surety expenses for environmental matters amounted to $20 million in and other bonds, issued by highly rated financial institutions, to 2015, $20 million in 2014 and $18 million in 2013. In addition, third parties to indemnify them in the event the Company does based on the results of its operations and maintenance programs, not perform its contractual obligations. As at December 31, 2015, as well as ongoing environmental audits and other factors, the the maximum potential liability under these guarantee instruments Company plans for specific capital improvements on an annual was $671 million ($593 million as at December 31, 2014), of basis. Certain of these improvements help ensure facilities, such which $589 million ($525 million as at December 31, 2014) related as fuelling stations and waste water and storm water treatment to workers’ compensation and other employee benefit liabilities systems, comply with environmental standards and include new and $82 million ($68 million as at December 31, 2014) related to construction and the updating of existing systems and/or processes. other liabilities. The letters of credit were drawn on the Company’s Other capital expenditures relate to assessing and remediating bilateral letter of credit facilities. The guarantee instruments expire certain impaired properties. The Company’s environmental capital at various dates between 2016 and 2018. expenditures amounted to $18 million in 2015, $19 million in 2014 and $10 million in 2013. Guarantees and indemnifications The Company has not recorded a liability as at December 31, 2015 with respect to its guarantee instruments as they related to the Company’s future performance and the Company did not expect to In the normal course of business, the Company, including certain of make any payments under its guarantee instruments. its subsidiaries, enters into agreements that may involve providing guarantees or indemnifications to third parties and others, which General indemnifications may extend beyond the term of the agreements. These include, but In the normal course of business, the Company provides indemni- are not limited to, residual value guarantees on operating leases, fications, customary for the type of transaction or for the railway standby letters of credit, surety and other bonds, and indemnifi- business, in various agreements with third parties, including cations that are customary for the type of transaction or for the indemnification provisions where the Company would be required railway business. Guarantees to indemnify third parties and others. During the year, the Company entered into various contracts with third parties for which an indemnification was provided. Due to the nature of the indem- Guarantee of residual values of operating leases nification clauses, the maximum exposure for future payments The Company has guaranteed a portion of the residual values cannot be reasonably determined. To the extent of any actual claims of certain of its assets under operating leases with expiry dates under these agreements, the Company maintains provisions for between 2016 and 2022, for the benefit of the lessor. If the fair such items, which it considers to be adequate. As at December 31, value of the assets at the end of their respective lease term is less 2015, the Company has not recorded a liability with respect to any than the fair value, as estimated at the inception of the lease, then indemnifications. the Company must, under certain conditions, compensate the lessor for the shortfall. As at December 31, 2015, the maximum exposure in respect of these guarantees was $200 million ($194 million as at December 31, 2014). There are no recourse provisions to recover any amounts from third parties. CN | 2015 Annual Report 87 Notes to Consolidated Financial Statements 17 | Financial instruments Risk management The Company also enters into foreign exchange forward contracts to manage its exposure to foreign currency risk. As at December 31, 2015, the Company had outstanding foreign In the normal course of business, the Company is exposed to exchange forward contracts with a notional value of US$361 million various risks from its use of financial instruments. To manage these (US$350 million as at December 31, 2014). Changes in the fair risks, the Company follows a financial risk management framework, value of foreign exchange forward contracts, resulting from changes which is monitored and approved by the Company’s Finance Committee, with a goal of maintaining a strong balance sheet, optimizing earnings per share and free cash flow, financing its in foreign exchange rates, are recognized in Other income in the Consolidated Statement of Income as they occur. For the years ended December 31, 2015, 2014 and 2013, the Company recorded operations at an optimal cost of capital and preserving its liquidity. a gain of $61 million, $9 million, and $6 million, respectively, related The Company has limited involvement with derivative financial instruments in the management of its risks and does not hold or issue them for trading or speculative purposes. Foreign currency risk The Company conducts its business in both Canada and the U.S. to foreign exchange forward contracts. These gains were largely offset by losses related to the re-measurement of other US dollar- denominated monetary assets and liabilities recognized in Other income. As at December 31, 2015, Other current assets included an unrealized gain of $4 million ($9 million as at December 31, 2014) and Accounts payable and other included an unrealized and as a result, is affected by currency fluctuations. Changes in the loss of $2 million (nil as at December 31, 2014), related to foreign exchange rate between the Canadian dollar and the US dollar affect exchange forward contracts. the Company’s revenues and expenses. To manage foreign currency risk, the Company designates US dollar-denominated long-term Interest rate risk debt of the parent company as a foreign currency hedge of its net investment in U.S. subsidiaries. As a result, from the dates of The Company is exposed to interest rate risk, which is the risk that the fair value or future cash flows of a financial instrument will vary designation, foreign exchange gains and losses on translation of the as a result of changes in market interest rates. Such risk exists in Company’s US dollar-denominated long-term debt are recorded in Accumulated other comprehensive loss, which minimizes volatility relation to the Company’s long-term debt. The Company mainly issues fixed-rate debt, which exposes the Company to variability of earnings resulting from the conversion of US dollar-denominated in the fair value of the debt. The Company also issues debt with long-term debt into the Canadian dollar. variable interest rates, which exposes the Company to variability in interest expense. To manage interest rate risk, the Company manages its borrowings in line with liquidity needs, maturity schedule, and currency and interest rate profile. In anticipation of future debt issuances, the Company may use derivative instruments such as forward rate agreements. The Company does not currently hold any significant derivative instruments to manage its interest rate risk. As at December 31, 2015, Accumulated other comprehensive loss included an unamortized gain of $7 million ($7 million as at December 31, 2014) relating to treasury lock transactions settled in a prior year, which is being amortized over the term of the related debt. 88 CN | 2015 Annual Report Notes to Consolidated Financial Statements Fair value of financial instruments The following table provides the valuation methods and assumptions used by the Company to estimate the fair value of financial instruments and their associated level within the fair value hierarchy: Level 1 The carrying amounts of Cash and cash equivalents and Restricted cash and cash equivalents approximate fair value. Quoted prices for These financial instruments include highly liquid investments purchased three months or less from maturity, for identical instruments which the fair value is determined by reference to quoted prices in active markets. in active markets Level 2 The carrying amounts of Accounts receivable, Other current assets, and Accounts payable and other approximate Significant inputs fair value. The fair value of these financial instruments is not determined using quoted prices, but rather from (other than quoted market observable information. The fair value of derivative financial instruments used to manage the Company’s prices included exposure to foreign currency risk and included in Other current assets and Accounts payable and other is measured in Level 1) are by discounting future cash flows using a discount rate derived from market data for financial instruments subject to observable similar risks and maturities. The carrying amount of the Company’s debt does not approximate fair value. The fair value is estimated based on quoted market prices for the same or similar debt instruments, as well as discounted cash flows using current interest rates for debt with similar terms, company rating, and remaining maturity. As at December 31, 2015, the Company’s debt had a carrying amount of $10,427 million ($8,372 million as at December 31, 2014) and a fair value of $11,720 million ($9,767 million as at December 31, 2014). Level 3 The carrying amounts of investments included in Intangible and other assets approximate fair value, with the Significant inputs are exception of certain cost investments for which significant inputs are unobservable and fair value is estimated based unobservable on the Company’s proportionate share of the underlying net assets. As at December 31, 2015, the Company’s investments had a carrying amount of $69 million ($58 million as at December 31, 2014) and a fair value of $220 million ($183 million as at December 31, 2014). CN | 2015 Annual Report 89 Notes to Consolidated Financial Statements 18 | Segmented information For the years ended December 31, 2015, 2014 and 2013, no major customer accounted for more than 10% of total revenues The Company manages its operations as one business segment over and the largest rail freight customer represented approximately 3%, a single network that spans vast geographic distances and territor- 2%, and 2%, respectively, of total rail freight revenues. The following tables provide information by geographic area: In millions Year ended December 31, 2015 2014 2013 ies, with operations in Canada and the U.S. Financial information reported at this level, such as revenues, operating income, and cash flow from operations, is used by corporate management, including the Company’s chief operating decision-maker, in evaluating financial and operational performance and allocating resources across CN’s network. The Company’s strategic initiatives, which drive its operational direction, are developed and managed centrally by corporate management and are communicated to its regional activity centers (the Western Region, Eastern Region and Southern Region). Revenues Canada U.S. Total revenues Net income Canada U.S. $ 8,283 $ 8,108 $ 7,149 4,328 4,026 3,426 $ 12,611 $ 12,134 $ 10,575 $ 2,469 $ 2,249 $ 1,762 1,069 918 850 $ 3,538 $ 3,167 $ 2,612 Corporate management is responsible for, among others, CN’s Total net income marketing strategy, the management of large customer accounts, overall planning and control of infrastructure and rolling stock, the allocation of resources, and other functions such as financial planning, accounting and treasury. The role of each region is to manage the day-to-day service requirements within their respective territories and control direct costs incurred locally. Such cost control is required to ensure that pre-established efficiency standards set at the corporate level are met. The regions execute the overall corporate strategy and operating plan established by corporate management, as their management of throughput and control of direct costs does not serve as the platform for the Company’s decision-making process. Approximately 95% of the Company’s freight revenues are from national accounts for which freight traffic spans North America and touches various commodity groups. As a result, the Company does not manage revenues on a regional basis since a large number of the movements originate in one region and pass through and/or terminate in another region. The regions also demonstrate common characteristics in each of the following areas: • each region’s sole business activity is the transportation of In millions Properties Canada U.S. Total properties December 31, 2015 2014 $ 16,737 $ 15,798 15,887 12,716 $ 32,624 $ 28,514 19 | Subsequent event Shelf prospectus and registration statement On January 5, 2016, the Company filed a new shelf prospectus with the Canadian securities regulators and a registration state- ment with the United States Securities and Exchange Commission (SEC), pursuant to which CN may issue up to $6.0 billion of debt securities in the Canadian and U.S. markets over the next 25 months. This shelf prospectus and registration statement replaces CN’s previous shelf prospectus and registration statement that was filed on December 3, 2013. Access to capital markets under the shelf prospectus and registration statement is dependent on freight over the Company’s extensive rail network; market conditions. • the regions service national accounts that extend over the Company’s various commodity groups and across its rail network; • the services offered by the Company stem predominantly from the transportation of freight by rail with the goal of optimizing the rail network as a whole; and • the Company and its subsidiaries, not its regions, are subject to single regulatory regimes in both Canada and the U.S. 90 CN | 2015 Annual Report Notes to Consolidated Financial Statements Corporate Governance – Delivering Responsibly CN is committed to being a responsible corporate citizen. At Because it is important to CN to uphold the highest standards in CN, sound corporate citizenship touches nearly every aspect of corporate governance and that any potential or real wrong doings what we do, from governance to business ethics, from safety to be reported, CN has also adopted methods allowing employees and environmental protection. Central to this comprehensive approach third parties to report accounting, auditing and other concerns, as is our strong belief that good corporate citizenship is simply good more fully described on our website. business. We are proud of our corporate governance practices. For more CN has always recognized the importance of good governance. information on these practices, please refer to our website, as well As it evolved from a Canadian institution to a North American as to our proxy circular – mailed to our shareholders and also avail- publicly traded company, CN voluntarily followed certain corporate able on our website. CN understands that our long-term success is governance requirements that, as a company based in Canada, connected to our contribution to a sustainable future. That is why it was not technically compelled to follow. We continue to do so we are committed to the safety of our employees, the public and today. Since many of our peers – and shareholders – are based the environment; delivering reliable, efficient service so our cus- in the United States, we want to provide the same assurances of tomers succeed in global markets; building stronger communities; sound practices as our U.S. competitors. and providing a great place to work. Our sustainability activities are Hence, we adopt and adhere to corporate governance prac- outlined in our Delivering Responsibly report, which can be found tices that either meet or exceed applicable Canadian and U.S. on our website: www.cn.ca corporate governance standards. As a Canadian reporting issuer For the fourth straight year, CN’s practices have earned it a place with securities listed on the Toronto Stock Exchange (TSX) and the on the Dow Jones Sustainability World Index (DJSI), which includes New York Stock Exchange (NYSE), CN complies with applicable rules an assessment of CN’s governance practices, in addition to being adopted by the Canadian Securities Administrators and the rules of named to the DJSI North America index for the seventh consecutive the U.S. Securities and Exchange Commission giving effect to the year. CN was also recognized for climate change transparency for provisions of the U.S. Sarbanes-Oxley Act of 2002. the seventh year in a row by earning a position in CDP’s Canada As a Canadian company, we are not required to comply with 200 Climate Disclosure Leadership Index. many of the NYSE corporate governance rules, and instead may CN received the Best Corporate Governance Award from comply with Canadian governance practices. However, except IR Magazine in 2009, 2010, 2014 and 2015. CN was also as summarized on our website (www.cn.ca in the Delivering recognized in the Globe and Mail’s 2015 annual review of Responsibly – Governance section), our governance prac tices Corporate Governance in Canada, where CN ranked fifth overall comply with the NYSE corporate governance rules in all significant and first in its industrial group. As well, in 2011 we received respects. the Canadian Coalition for Good Governance (CCGG) Award Consistent with the belief that ethical conduct goes beyond for Best Disclosure of Board Governance Practices and Director compliance and resides in a solid governance culture, the Qualifications; and in 2012 the CCGG Award for Best Disclosure Delivering Responsibly – Governance section on the CN website of Approach to Executive Compensation. contains CN’s Corporate Governance Manual (including the charters of our Board and of our Board committees) and CN’s Code of Business Conduct. Printed versions of these documents are also available upon request to CN’s Corporate Secretary. CN | 2015 Annual Report 91 Shareholder and Investor Information Annual meeting The annual meeting of shareholders will be held at 10:00 a.m. EDT on April 26, 2016 at: Le Windsor Windsor Ballroom 1170 Peel Street Montreal, Quebec, Canada Annual information form The annual information form may be obtained by writing to: The Corporate Secretary Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 It is also available on CN’s website. Transfer agent and registrar Computershare Trust Company of Canada Offices in: Montreal, Quebec Toronto, Ontario Calgary, Alberta Vancouver, British Columbia Telephone: 1-800-564-6253 www.investorcentre.com Co-transfer agent and co-registrar Computershare Trust Company N.A. Att: Stock Transfer Department Overnight Mail Delivery: 250 Royall Street, Canton MA 02021 Regular Mail Delivery: P.O. Box 43078, Providence, RI 02940-3078 Telephone: 1-800-962-4284 Shareholder services Shareholders having inquiries concerning their shares, wishing to obtain information about CN, or to receive dividends by direct deposit or in U.S. dollars may obtain detailed information by communicating with: Computershare Trust Company of Canada Shareholder Services 100 University Avenue, 8th Floor Toronto, Ontario M5J 2Y1 Telephone: 1-800-564-6253 www.investorcentre.com Stock exchanges CN common shares are listed on the Toronto and New York stock exchanges. Ticker symbols: CNR (Toronto Stock Exchange) CNI (New York Stock Exchange) Investor relations Sam Forgione Vice-President, Investor Relations Telephone: 514-399-0052 Head office Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 P.O. Box 8100 Montreal, Quebec H3C 3N4 Additional copies of this report are available from: CN Public Affairs 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Telephone: 1-888-888-5909 Email: contact@cn.ca La version française du présent rapport est disponible à l’adresse suivante : Affaires publiques du CN 935, rue de La Gauchetière Ouest Montréal (Québec) H3B 2M9 Téléphone : 1 888 888-5909 Courriel : contact@cn.ca 92 CN | 2015 Annual Report This report has been printed on 100% post-consumer paper. 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 www.cn.ca