Wednesday, November 01, 2006

Bank Earnings, Dividends, & Taxes

BMO Capital Markets, 1 November 2006

Trust Conversion was Never in the Cards

• Even before yesterday’s initative by the federal government to directly tax income trusts, Canadian banks were unlikely to convert to income trusts in whole (or in part) for structural reasons outlined in previous commentaries (see report “In Response to a Wacky Question: Can Banks Become Income Trusts?”, September 12, 2005). In addition, from a tax efficiency standpoint, conversion was almost unnecessary.

• We believe banks and their taxable shareholders are achieving a level of tax efficiency equivalent to or better than a trust structure. Specifically, we note that the combined tax take for government coming from bank corporate paid income tax and personal taxes (taxes on bank dividends) amounts to an attractive 39% of pre-tax earnings currently. An equivalent analysis of most income trusts would imply that the combined tax take would be 46%—the marginal personal income tax rate.

• Of course, the initiative to directly tax income trusts (which according to the changes announced last night will be done by 2011) will also ensure that the tax advantage offered to non-taxable and foreign investors by trusts versus banks is also removed. Recall that trusts held in such vehicles (and by such investors) were effectively eliminating or deferring the tax burden. In 2011, these entities, like banks, will pay some material amount of tax up front.

• A reduced tax burden should be a continuing source of bank earnings and dividend growth and is a factor supporting our Outperform rating for bank stocks. Over the next four years we believe the annual tax burden borne by banks will grow only at a 3% annual rate, while bank earnings will grow at about an 8% annual rate and dividends at an 11% annual rate.

Bank Tax Facts

The accompanying table outlines a number of tax-related bank facts. The table looks at the last 10 years and presents a forecast for the next four years. Much of the data are estimates (which we generally believe are conservative) and are meant to convey a trend and the big picture. We believe the general conclusions apply to all banks and no individual bank stands out, plus or minus, versus the others (with regard to tax-related issues).

The key conclusions/observations we draw from the information in the table are highlighted below.

1. Bank tax rates have been declining for the last 10 years and are expected to continue declining over the next four years.

2. The decline in the bank tax burden has increased the annual rate of growth in bank earnings over the last 10 years (to 10.6% from 7.3%). Further tax rate reductions will augment earnings growth over the next four years, but the impact will be less pronounced. Specifically, we believe that pre-tax earnings growth of 6.4% annually will result in a 7.8% increase in after-tax earnings. Clearly, banks will be more dependent on “core earnings growth” and this is one reason that we assume that overall earnings growth slows.

3. Bank dividend payout ratios are rising largely due to excess capital generation. However, an additional consideration is the recent reduction in taxation of dividend income at the individual level (in 2006 from 32% to 21%). Bank common dividends, on an after-tax basis to the taxable individual investor, have grown at a 15.9% annual rate over the last 10 years and are projected to grow at a 12.0% annual rate over the next four years.

4. The combined corporate/personal tax rate is projected to decline to 36% by 2010, which is significantly less than the marginal tax rate for individuals (projected to be 44% in 2010). The taxable individual should prefer Canadian bank dividends to income trust distributions.

5. Although growing slowly, Canadian banks directly and indirectly remain large tax payers (close to an estimated $10 billion worldwide in 2010, excluding capital gains taxes paid by their owners who occasionally sell shares).

6. The decline in bank tax burden, past and future, is a function of both external and internal developments. Governments in Canada, especially at the Federal level, have moved to reduce the level of taxation. The statutory combined federal and provincial corporate income tax rate for large corporations will have declined from 42.4% to 31.0% over the 14-year period ending 2010. Certain hidden taxes, such as Canada Deposit Insurance Premiums and Federal capital taxes, have been greatly reduced in recent years with further relief likely (i.e. reduced GST, some reduction in provincial capital taxes, etc.). Recent enhancement of the dividend tax credit has reduced the marginal tax rate on dividends to the taxable individual investor from 32% to 21%.

Internally, banks have become more efficient in managing their global tax position. They have increased their investment in securities that generate tax-exempt income and increased the proportion of income generated in foreign jurisdictions.

7. Over the last 10 years, reductions in domestic tax rates and “hidden taxes” (defined in the footnotes to our table) have accounted for about 60% of the lower tax burden for banks and their owners. The other 40% has come from internal tax management initiatives, including increased amounts of income earned in low-tax jurisdictions and increased investment in securities that produce tax-exempt income.

Over the next four years, we have assumed that 100% of the reduced tax burden is derived from the expected reduction in domestic income tax rates and hidden taxes. We consider this a conservative assumption.