Manulife involved in "blatantly abusive tax shelter"

Manulife in hot water over tax shelter

Eoin Callan, Financial Post
January 06, 2009


Manulife Financial Corp. is attempting to take advantage of the credit crisis to cash in early on a complex financial transaction that lawmakers view as a "tax shelter scam" and were due to shut down.

Canada's largest insurer on Monday turned to a U.S. court to force a rural electricity cooperative in Indiana to make an immediate US$120-million payment under the tax avoidance scheme in a move that would force the non-profit utility into bankruptcy.

The windfall would provide Manulife with a cash injection at a time when its U.S. subsidiary, John Hancock Financial, is draining capital from the parent company because of heavy exposures to volatile financial markets and is being claimed early because of a slip in the credit rating of one of the parties to the controversial transaction.

But the aggressive move is inciting fury on Capitol Hill, where influential members of Congress say the company is exploiting a legal loop hole to claim money it is not legitimately entitled to given recent findings that the underlying tax scheme is abusive.

Spurred on by Manulife's court action, a Democratic Senator is drawing up a new law that would apply a punitive excise tax on the Canadian insurer and any other financial institution that took similar steps, according to congressional aides.

At the heart of the fractious dispute that could jeopardize the power supply to 350,000 homes in the U.S. heartland is an opaque tax scheme that briefly gained popularity a few years ago among accountants working on behalf of insurers and banks with an appetite for risk.

Under the complex structure, financial investors entered into deals with non-profit utilities in the United States in which they acquired generating stations and train tracks and then immediately leased the assets backed to the co-operatives.

The exchanges of assets only took place on paper and had no underlying economic substance, but allowed financial companies to claim tax benefits the non-profit groups had no use for. But the deals have since been deemed abusive by U.S. authorities and were described as "shady tax shelters" and a "tax shelter scam" in Congress last month by Montana Senator Max Baucus.

While it is not clear how many of these transactions Manulife is involved in, public records suggest it is party to at least three similar deals.

The Internal Revenue Service is understood to be probing these transactions and pursuing a settlement with the Canadian insurer along the lines of earlier deals in which financial companies surrendered 80% of the withheld taxes.

The probe is understood to include the deal initiated in 2002 by Manulife's U.S. subsidiary, John Hancock, with the Hoosier Energy Rural Electric Cooperative, which led to the Toronto-based insurer owning parts of an electricity generator on the Wabash River in Indiana's corn belt.

As things stood before the credit crisis struck, that deal looked set to be wound down along with the others targeted by the IRS.

"The IRS will certainly deny the benefits that John Hancock is claiming," according to Joseph Bankman, a Stanford law professor whose opinion was submitted to a U.S. court on Monday.

But in the fine print of the 4,000-page agreement detailing the original transaction with the non-profit group is a clause that required the deal to be backed up by a financial guarantor with a triple-A credit rating in case the utility defaulted on its lease payments.

While Hoosier has never faltered in its commitments to Manulife under the deal, the financial guarantor -- Ambac -- has seen its credit rating downgraded amid the credit crisis along with many backers of so-called credit default swaps.

Manulife has seized on the change in the credit rating to claim a $120-million payment under the credit default swap for "early termination," allowing it to collect the tax benefits upfront.

Lawmakers and a lower Indiana court have dismissed this as a technical default given the guarantor is still backing the deal and Manulife could not reasonably expect to enjoy the tax benefits anticipated when the original deal was struck.

Hoosier argued before an appeal court on Monday that the claim by Manulife combined "some of the worst aspects of modern finance" that "combines the sometimes toxic intricacies of credit default swaps and investment derivatives with a blatantly abusive tax shelter."

Manulife declined to comment.