The surtax is just one potential new revenue source that the federal government is examining, raising the question of whether the sector is now facing rising political riskFred Lum/The Globe and Mail
The Canadian political landscape may look remarkably similar the day after Justin Trudeau’s Liberals were re-elected to another minority government. But investors are facing something new: The Liberal victory means that the party’s pledge to impose additional taxes on banks and insurers now has traction.
In August, the Liberals said that if re-elected they would impose a 3-per-cent surtax on financial firms that generate an annual profit of more than $1-billion – a measure that would apply to all of the Big Six banks, along with Great-West Lifeco Inc., Manulife Financial Corp. and Sun Life Financial Inc.
The problem for investors here: The surtax is just one potential new revenue source that the federal government is examining, raising the question of whether this dividend-generating sector is now facing rising political risk that will weigh on valuations.
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“We have some concern that this group of companies has made it onto the ‘naughty list’ and increased scrutiny may cause some spillover into other business practices and go beyond pure taxation,” Darko Mihelic, an analyst at RBC Dominion Securities, said in a postelection research note.
The Liberals estimate that the surtax, along with a four-year temporary fee called the “Canada recovery dividend,” will generate a combined minimum of $2.5-billion a year over the next four years – a threat big enough to halt an encouraging bank stock rally that peaked in late August.
Since then, bank stocks have fallen by an average of nearly 5 per cent, compared with a 1.3-per-cent decline by the S&P/TSX Composite Index over the same period.
But Mr. Mihelic has come up with additional numbers weighing on financial firms as Liberals look for new government revenue.
The Liberals want to restrict the ability of federally regulated entities, which include banks and insurers, to use tiered ownership structures that distribute Canadian profits to jurisdictions with lower tax rates. Squeezing these structures could generate $1.2-billion in the next fiscal year, rising to $4.7-billion annually at the end of four years, Mr. Mihelic estimates.
The Liberals also plan to inject more funding into the Canada Revenue Agency, which could mean that the government will double down on a continuing case that challenges the way large banks deducted tax on certain dividends paid between 2009 and 2016. The current amount of money in dispute: $7.5-billion.
“The banks have not set aside any reserves for this potential tax bill,” Mr. Mihelic said in his note.
The good news for investors? Mr. Mihelic believes that the decline in bank stocks over the past several weeks suggests that the surtax and Canada recovery dividend are largely priced in. Bank stocks, which are the most exposed to the potential changes, trailed a modest rebound in the S&P/TSX Composite Index on Tuesday but saw some gains.
Also, the Liberal proposals have landed at a time when bank stock valuations are hardly lofty, suggesting that investor enthusiasm for the sector had been somewhat muted anyway, leaving the stocks less vulnerable to setbacks.
According to RBC Dominion Securities, share prices relative to book value and estimated earnings – two popular methods used by analysts for assessing bank stock valuations – are well below the 15-year average. For insurers, share prices are slightly above the 15-year average for book value, but look quite cheap using estimated earnings.
But the question now is whether the new political tone will persist, putting additional pressure on valuations and limiting further rallies.
Prior to the election, analysts believed that Liberal campaign pledges were not enough to blunt a bullish approach to the big banks for longer-term investors, since the sector stood to benefit from the rebounding economy, recovery of credit losses and the eventual return of dividend hikes.
Now that the Liberals have won a new mandate to govern, though, a hypothetical threat has become more real – and potentially bigger.
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