Thursday, March 22, 2007

New Budget Measure Could Pose Impediment to Financial Sector

  
The Globe and Mail, Steven Chase & Tara Perkins, 22 March 2007

Federal Finance Minister Jim Flaherty's office declared yesterday that it has no intention of backing away from a controversial budget move to scrap the tax deductibility of interest that companies incur to fund foreign operations.

Taxation experts have warned this measure – which Finance describes as eliminating an undesirable tax subsidy – could pose a major impediment to banks and other Canadian companies that want to make foreign acquisitions.

Mr. Flaherty's office spoke yesterday to clarify the Finance Minister's intent on the heels of reports suggesting he might reconsider the move.

“He's not backing down,” said Dan Miles, director of communications for the Finance Minister. “The policy is the policy.”

Mr. Flaherty said earlier this week that he would consult “stakeholders” – that could include affected companies and tax experts – so that Finance could design the implementing legislation “in the best way possible.”

But Mr. Flaherty was also clear that he was “satisfied” with the measure as proposed in the budget.

Under new measures outlined in the budget, Canadian companies borrowing money to finance foreign deals will no longer be able to deduct the interest costs against their Canadian income.

The 2007 budget document makes clear Finance considers the target of its action a subsidy that it says hurts Canada by encouraging the export of business operations.

Allan Lanthier, a retired senior partner of Ernst & Young and immediate past chairman of the Canadian Tax Foundation, warned yesterday that the budget move would hurt banks.

“I've been practising tax for 35 years – this is the single most misguided proposal I've seen out of Ottawa in 35 years, Mr. Lanthier said.

The proposal could also result in a number of large Canadian companies being put on the auction block, he said.

“A number of Canadian multinationals have become takeover targets,” he said. “You now have a Canadian multinational that's in a very tax-inefficient position, and that fact won't be lost on foreign purchasers. I think many of them may well become the subject of hostile takeover bids...

“This measure would put Canadian companies at a significant competitive disadvantage, and I think the economic fallout to the Canadian economy is potentially disastrous,” he said. “And I don't think the Finance Minister understands that, I don't think he was properly advised by his Finance officials.”

Compared with 10 years ago, “there are fewer Canadian multinationals now, they are more at risk, they are less robust, and other jurisdictions are creating fiscal climates to allow their domestic multinationals to expand,” he said.

Mr. Lanthier is suffering from a bit of guilt. He was one of the members of the Mintz committee, which recommended a similar measure a decade ago, although it had some differences, such as a grandfathering period.

Canadian banks are on high alert over the proposed change.

Royal Bank of Canada's Jim Westlake, head of Canadian retail banking, said yesterday: “Anything that would hurt growth and not support Canadian businesses abroad, we don't like. On the surface, it appears this tax may contain elements of that.”

Ogilvy Renault LLP tax expert Leonard Farber says the impact of the proposed measure is huge.

It “represents a major shift in long-standing policy affecting investment offshore but particularly Canadian multinationals,” said Mr. Farber, a former Finance official.

The budget – which only provides detailed fiscal data two years into the future – estimates that this will collect $10-million in 2007-08 and $40-million annually by 2009-10.

But experts warn the amount clawed back from Canadian companies each year by this measure would actually be hundreds of million of dollars. “Forty million dollars seems way low. It is probably much larger, to a magnitude of ten or twenty,” said one bank official who requested anonymity.

Finance watchers say the low official estimate is likely because the government is planning to grandfather some existing corporate activities. But over time, the extra taxes will climb, they predict.
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BMO Capital Markets, 20 March 2007

In yesterday's budget, the Federal Government proposed changes on the tax deductibility of interest payments and foreign affiliates. Specifically, corporations can issue debt in Canada (and enjoy the tax benefits) to fund foreign affiliates. However, when the earnings from the foreign affiliates are 'dividended' back up to the parent company, this dividend income is not necessarily taxed.

In the budget document, the government states that there is one "important kind of dividend income that does not get taxed in Canada. This is dividend income that a foreign subsidiary corporation, known as a foreign affiliate, pays to its Canadian parent company out of the foreign affiliate's 'exempt surplus'-its foreign business income. Despite the fact that these exempt surplus dividends are not taxed in Canada (and neither is the underlying foreign income), the parent company in Canada can deduct the interest it pays on borrowed money used to acquire the shares of the foreign affiliate."

In effect, the government is trying to eliminate the tax benefit of debt issued in Canada to fund non-taxable earnings from its foreign affiliates. In the budget proposal, the government could not have been clearer when it stated that, 'the [tax] system must ensure that appropriate taxes are paid so that everyone pays their fair share. Some corporations, both foreign-owned and Canadian, have taken advantage of Canada's tax rules to avoid tax.'

What does this mean for the lifecos? The Canadian life insurers are global companies with operations in lower tax jurisdictions including Asia, Ireland, and other parts of Europe as well as reinsurance operations in tax efÞ cient jurisdictions like the Caribbean. Almost all of these jurisdictions are growing faster than the domestic market. Accordingly, as earnings grow in other low tax jurisdictions, like Asia, we would expect there to be a natural bias downward in a life insurer's consolidated tax rate, particularly at Manulife and Sun Life.

However, we believe that other tax planning measures were underway to help lower consolidate tax rates and that most of this tax planning is unlikely to beneÞ t shareholders given the proposed new budget rules.

The consolidated tax rates and the reported tax rates in Canada for the four life insurers is presented in Table 1 below. Of note, reported consolidated and Canadian tax rates in 2006 benefited from the reduction in corporate tax rates announced in Canada last year that involved some non-cash charges. We believe that consolidated tax rates for the Canadian lifecos in the mid-20s appear reasonable given their extensive global insurance and reinsurance operations. The cash tax rates are can be considerably lower than the accrued tax rates reported in consolidated income statements.

Due to its long tailed nature, life insurance accounting tends to be complex and life insurance tax accounting only adds an additional layer of complexity. As one of the CEOs mentioned during a conference call when asked about taxes, he indicated that they 'file aggressively but account conservatively.' As a result, gauging the potential impact of these changes on the lifecos is challenging.

Our initial analysis suggests that these changes could reduce earnings by 1-2% based on the assumption that some portion of the benefits derived from lower effective tax rates on income not subject to tax in Canada would be affected by these proposed changes. In 2005, which is the latest available data, lower effective tax rates on income not subject to tax in Canada reduced taxes by 10-15% at the three large life insurers: Great-West, Sun Life, and Manulife. On a relative basis, we believe that Sun Life and Great-West have more exposure to these changes than Manulife.

At this stage, we believe that this is the worst case scenario. More likely in our view is that these changes are likely to create some headwinds in terms of EPS growth. As mentioned above, the Canadian life insurers are global companies with operations in lower tax jurisdictions including Asia, Ireland, and other parts of Europe as well as reinsurance operations in tax efficient jurisdictions like the Caribbean. Almost all of these jurisdictions are growing faster than the domestic market. Accordingly, as earnings grow in other low tax jurisdictions, like Asia, we would expect there to be a natural bias downward in a life insurer's consolidated tax rate, particularly at Manulife and Sun Life. This is our initial analysis and we expect to update our views over the coming days and weeks as we get greater clarity on the details. The life insurers remain Outperform rated.
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BMO Capital Markets, 20 March 2007

In yesterday's budget, the Federal Government proposed changes on the tax deductibility of interest payments and foreign affiliates. Specifically, corporations can issue debt in Canada (and enjoy the tax benefits) to fund foreign affiliates. However, when the earnings from the foreign affiliates are 'dividended' back up to the parent company, this dividend income is not necessarily taxed.

In the budget document, the government states that there is one "important kind of dividend income that does not get taxed in Canada. This is dividend income that a foreign subsidiary corporation, known as a foreign affiliate, pays to its Canadian parent company out of the foreign affiliate's 'exempt surplus'-its foreign business income. Despite the fact that these exempt surplus dividends are not taxed in Canada (and neither is the underlying foreign income), the parent company in Canada can deduct the interest it pays on borrowed money used to acquire the shares of the foreign affiliate."

In effect, the government is trying to eliminate the tax benefit of debt issued in Canada to fund non-taxable earnings from its foreign affiliates. In the budget proposal, the government could not have been clearer when it stated that, 'the [tax] system must ensure that appropriate taxes are paid so that everyone pays their fair share. Some corporations, both foreign-owned and Canadian, have taken advantage of Canada's tax rules to avoid tax.'

What does this mean for the lifecos? The Canadian life insurers are global companies with operations in lower tax jurisdictions including Asia, Ireland, and other parts of Europe as well as reinsurance operations in tax efÞ cient jurisdictions like the Caribbean. Almost all of these jurisdictions are growing faster than the domestic market. Accordingly, as earnings grow in other low tax jurisdictions, like Asia, we would expect there to be a natural bias downward in a life insurer's consolidated tax rate, particularly at Manulife and Sun Life.

However, we believe that other tax planning measures were underway to help lower consolidate tax rates and that most of this tax planning is unlikely to beneÞ t shareholders given the proposed new budget rules.

The consolidated tax rates and the reported tax rates in Canada for the four life insurers is presented in Table 1 below. Of note, reported consolidated and Canadian tax rates in 2006 benefited from the reduction in corporate tax rates announced in Canada last year that involved some non-cash charges. We believe that consolidated tax rates for the Canadian lifecos in the mid-20s appear reasonable given their extensive global insurance and reinsurance operations. The cash tax rates are can be considerably lower than the accrued tax rates reported in consolidated income statements.

Due to its long tailed nature, life insurance accounting tends to be complex and life insurance tax accounting only adds an additional layer of complexity. As one of the CEOs mentioned during a conference call when asked about taxes, he indicated that they 'file aggressively but account conservatively.' As a result, gauging the potential impact of these changes on the lifecos is challenging.

Our initial analysis suggests that these changes could reduce earnings by 1-2% based on the assumption that some portion of the benefits derived from lower effective tax rates on income not subject to tax in Canada would be affected by these proposed changes. In 2005, which is the latest available data, lower effective tax rates on income not subject to tax in Canada reduced taxes by 10-15% at the three large life insurers: Great-West, Sun Life, and Manulife. On a relative basis, we believe that Sun Life and Great-West have more exposure to these changes than Manulife.

At this stage, we believe that this is the worst case scenario. More likely in our view is that these changes are likely to create some headwinds in terms of EPS growth. As mentioned above, the Canadian life insurers are global companies with operations in lower tax jurisdictions including Asia, Ireland, and other parts of Europe as well as reinsurance operations in tax efficient jurisdictions like the Caribbean. Almost all of these jurisdictions are growing faster than the domestic market. Accordingly, as earnings grow in other low tax jurisdictions, like Asia, we would expect there to be a natural bias downward in a life insurer's consolidated tax rate, particularly at Manulife and Sun Life. This is our initial analysis and we expect to update our views over the coming days and weeks as we get greater clarity on the details. The life insurers remain Outperform rated.
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