Jim Flaherty: Our backyard "global phenomenon"

In every possible respect, leveraged buyouts are much worse than income trusts (could ever be accused of being).


Anyone with knowledge of capital markets would have told you that the income trust tax would lead to a rash of takeovers of Canadian companies by foreign private equity.

Diane Francis wrote about in on December 3, 2006:

"The biggest blunder of all is that this policy announcement has discounted the income trust sector by $30 billion which represents a huge whack of the economic base of Canada"

"the resulting leverage buyout of the income trust sector will cost Ottawa dearly, thus putting more pressure on taxes from ordinary Canadians"

"Why wouldn't the Department of Finance, the Minister and Prime Minister understand this?"

It took Bay Street about a nano-second to realize it. Two nano-seconds later Wall Street realizes it. They thought Canadians were idiots. They were right.

As such, on November 3, 2006 there were rumors in the marketplace that New York based leveraged buyout firm KKR was going to take a run at government policy devalued BCE. So what did BCE do? Michael Sabia called KKR on November 3, 3006 and subsequently met with Henry Kravis in New York on November 15, 2006, which began a serious of events that made the obvious happen: BCE was acquired by foreign and domestic private equity in a leveraged buyout. Teachers’ only played a role because of the Canadian ownership hurdle that had to be overcome.

BCE is the perfect case study of why leveraged buyouts are much much worse than income trusts could ever be accused of being, on every conceivable government policy level.

Tax Loss: A business creates a finite amount of earnings before tax, and after necessary capital reinvestment. These excess earnings paid to unit holders under the income trust model are free of taxation and are instead taxed immediately in the hands of the unitholders. In the case of BCE these unitholders under an income trust would have been predominantly taxable investors and would have been taxed at the average rate of 38% (according to DoF). Meanwhile US investors would have paid a 15% withholding tax plus taxes in the US. Alternatively these pre-tax earnings are used to service the various security holders under the corporate model. In the case of the BCE leveraged buyout, the following is the capital structure

Equity from Teachers’ $4 billion
Equity from 3 US investors: $4 billion
Existing Debt: $12 billion
New Junk Bond Debt: $32 billion

As you can see, 85% of BCE’s new capitalization is debt, which causes BCE’s credit rating and credit worthiness to tank, thereby dramatically raising its cost of borrowing and overall cost of capital.

Under the corporate model, the interest used to service this debt is fully tax deductible. This is an indirect way of saying that these security holders receive the pretax earnings of BCE, just as is the case with income trust distributions. There are, however two very profound differences. First, these interest payments do not attract the 15% withholding tax, as with income trust distributions. Flaherty reduced the withholding tax on interest to ZERO in Budget 2007. Second ( as with BCE) this debt is being provided in large part by foreign lenders, meaning the earnings of BCE that are required to service it are being taxed in Canada at the rate of ZERO. This represents massive tax leakage. Under the trust model these earnings would be taxed at either 38% (if paid to Canadians) or 15% (if paid to foreigners) and would flow predominantly (greater than 85%) to Canadians and taxed at the rate of 38%.

Note to Ottawa and Canadian media: Both 38% and 15% are larger numbers than 0

Foreign Takeover Risk: Ottawa knew full well about the inherent takeover risk that would ensue if an income trust tax were to be imposed and they knew damn well where that risk would emanate from, namely leveraged buyout takeovers from foreign private equity. Meanwhile Flaherty tried to mislead Canadians about this hazard by saying private equity was a “global phenomenon”. Two points. Yes, I guess it is, just like the sub-prime mess is also a global phenomenon. And second, unlike other countries he had put the honey out for the bees, with his ill-conceived trust tax. Which is also rather “phenomenal” when you think about it. As in phenomenally stupid.

An internal Department of Finance memo warned senior officials who were directly responsible for the income trust tax policy about this risk, namely Mark Carney and Bob Hamilton and others. See Globe article entitled Trust tax linked to equity buyouts at http://www.investorvillage.com/groups.asp?mb=6966&mn=12586&pt=msg&mid=5291134

Higher Cost of Capital: As perverse as this sounds, income trusts were feared by people like Dominic D’Alessandro of Manulife Financial and Paul Desmarais Jr. of Power Corporation for the very fact that they represented a lower cost form of capital. Lower cost of capital ,ergo a higher valuation. This created pressure on them to convert, in order to attain these higher valuations. Here was the Globe’s account of November 2, 2006:

“High-profile directors and CEOs, meanwhile, had approached Mr. Flaherty personally to express their concerns: Many felt they were being pressed into trusts because of their duty to maximize shareholder value, despite their misgivings about the structure. Paul Desmarais Jr., the well-connected chairman of Power Corp. of Canada, even railed against trusts in a conversation with Prime Minister Stephen Harper during a trip to Mexico, and told him he should act quickly to stop the raft of conversions, according to sources.”

Here was the central preoccupation of D’Alesssandro’s testimony at the Public Hearings:

“In June of last year, CI Financial converted to trust status”.

Why would he have cared what CI Financial did in the previous year? Because it gave CI Financial a lower cost of capital. Who provided CI Financial with a lower cost of capital? Investors or taxpayers? In order for taxpayers to be the ones providing the lower cost of capital would require that Ottawa have foregone tax revenue from CI becoming an income trust. Such is not the case, and we can prove it. Has the government proven their case that income trusts result in less taxes than as corporations? No they have not. We look forward to being proven wrong on this point, in which case we will concede defeat.

In terms of BCE’s LBO, the leveraged buyout has burdened BCE with the highest cost of capital imaginable. BCE’s cost of debt has increased by at least 240 baisis points (2.40%) and their cost of equity matches the return expectations of its new owners, which means a number north of 30%. As a trust, BCE’s all-in cost of capital would have been 10-12% overall, with a cash cost of capital of 6.00%, which would have been the yield on the trust units.

You also have to ask yourself what these corporate self interests who lobbies Flaherty meant by “misgivings about the structure”. No reason to speculate, since it was obvious. They have all successfully learned how to “game” the corporate model through stock options and share buybacks. To make that scam possible means that they have to retain earnings for stock buybacks at times of maximum personal gain, rather than paying these earnings to the owners at regular monthly intervals at no personal gain.

Note to Ottawa and Canadian Media: Even lab mice will prefer more gain over less gain.

Lessened Competitiveness: Higher cost of capital translates into lowered competitiveness. Nowhere is this truer than in a higher capital intensive and rapidly changing business like telecommunications. The LBO of BCE is totally counter to this outcome> meanwhile one of the four policy objectives of Canada’s Telecommunications Act is to promote the competitiveness of Canadian telecom. One of the other four is to promote Canadian ownership of Canadian telecom. The LBO of BCE takes us in the complete opposite direction, not supported by the remaining two policy objectives of the Telecommunications Act.


Job Layoffs: One of the common themes of leverage buyouts is job layoffs. We witnessed this yesterday with the announcement of 2500 layoff of knowledge based workers at BCE. This is being driven by the need for higher returns that are required by the new owners and that are mandated by the massive new levels of debt. This is an observable reality around the world, which is why the global labour movement had called upon governments to halt this abusive tactic

See: Union spotlight at Davos on private equity raiders: http://www.union-network.org/uniindep.nsf/f0fa5a094742095ac125680000253538/ac73e13ac91e8b90c12572910057cae3?OpenDocument
See: Union bosses want action over the 'rodeo capitalism' of private equity: http://www.independent.co.uk/news/business/analysis-and-features/union-bosses-want-action-over-the-rodeo-capitalism-of-private-equity-435689.html


Systemic Risk to Canada’s fiscal health and the Economy: There is no greater risk to a financial market than too much debt. Debt represents one of the highest forms of risk for a financial system. Simply look at the situation involving the sub prime mortgage market or the somewhat analogous Asset Backed Commercial Paper Market in Canada. Too much debt is what causes bankruptcies. Nothing else causes bankruptcies. How is capitalizing BCE with 85% debt and only 15% of equity a prudent thing when no other peer phone company in the world has this kind of balance sheet risk. Are we as Canadians to take comfort when BCE’s lead financial advisor, Goldman Sachs writes to the company on June 29, 2007 , immediately after the leveraged buyout was announced that:

“We express no opinion as to the impact of the transaction on the solvency or viability of BCE or the ability of BCE to pay its obligations when they become due.”

Meanwhile the distributions paid on income trusts are not obligatory in nature. The opponents of income trusts try to portray this in a negative light. How can something as subject to business cycles and the risk of business be obligatory? Income trust distributions are subject to change in both the upward and downward direction. That is a good thing. As an income trust, BCE could never go insolvent. Just ask Goldman Sachs. As a debt leveraged buyout, BCE could very well go bankrupt. You don’t need to ask Goldman Sachs about tha one, as they already anticipated that question and that possible outcome.


Investor Demographics: We know who the investors in income trusts are. They are predominantly taxable Canadians who wish to prudently provide for their retirement income and to save for retirement. They also include pension fund investors and foreign individual investors. It takes no more than $1,000 for an investor to participate in the income trust market. No special membership in a pension plan is required. Meanwhile who are the private equity investors who are government is favouring with tax loss inducing policies. Truth is we don’t know. These private equity firms like Providence capital who bought a chunk of BCE are black boxes. Who knows whose capital they manage. Some of it is endowment money for wealthy US universities like Harvard and Yale. Some of it is money from Canadian pension funds. Much of it is from uber wealthy US citizens. And a good deal is from all four corners of the world, including the wealth of sovereign nations. One thing is for sure. 99.9% of income trust investors are precluded from investing in private equity leveraged buyouts. It takes a minimum of $5 million to participate in any of these name brand private equity funds. As a result the income trust tax is just another way to make Canadians squatters in their own country and subservient to foreigners at the hands of their own elected government.

Bottom Line:

So why would any sane and rational country want to introduce a tax policy that induces leveraged buyouts, that results in:

(1) Net loss of taxes. $800 million a year in the case of BCE, relative to an income trust. See http://www.caiti.info/resources_it_mythbusters.php#myth3
(2) Displacement of workers. 2500 so far in the case of BCE
(3) Introduction of systemic risk into the country’s economic well being: $34 billion new debt, displacing $34 billion of equity in the case of BCR
(4) increased cost of capital and resultant lessening of competitiveness. Immeasurable in the case of BCE, although they have already moved to increase phone service costs
(5) Displacement of Canadian investors in favour of foreign investors whose actual identity is not known

Again to quote Diane Francis: “Prove the case or drop the tax”