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Skyscrapers loom over a flagpole carrying the Canadian flag in the financial district in Toronto, March 11, 2009. (Mark Blinch/Reuters/Mark Blinch/Reuters)
Skyscrapers loom over a flagpole carrying the Canadian flag in the financial district in Toronto, March 11, 2009. (Mark Blinch/Reuters/Mark Blinch/Reuters)

Time to lead

Tax the banks? Look at the fine print of this game plan first Add to ...

They are rich, powerful, unloved, and they already send some of the biggest cheques to the Canada Revenue Agency. And that combination makes them a target for politicians who think it's time they sent a little more.

Canada's banks paid a combined $5.4-billion in federal and provincial income tax last year, making them among the country's largest corporate taxpayers. That's a big number, but as Ottawa stares down a $40-billion fiscal deficit, an argument is brewing over what that tax bill should be in the next few years.

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The major banks' immense profitability has fuelled calls from opposition politicians to raise corporate taxes. NDP Leader Jack Layton peppers his speeches with references to Conservative tax cuts for "big banks and big oil." Adrian Dix, who on the weekend was chosen the new leader of the British Columbia New Democrats, has promised to impose a new capital tax on banks at the provincial level, if elected.

It is by no means a purely Canadian story. Faced with budgetary shortfalls, governments around the world are casting an opportunistic eye on thriving industries as they search for ways to drum up more money to fund programs. And with the country's six largest banks having earned a collective $28-billion before taxes in 2010, the financial sector fits the description of a thriving industry.

"As the largest corporate cash taxpayers in the country, Canada's large banks may be perceived as easy targets," Bank of Montreal analyst John Reucassel said in a recent research note that looks closely at the taxes Canada's financial institutions pay.

But the equation the NDP and Liberals are proposing - higher corporate tax rates plus large bank profits equals a revenue bonanza for Ottawa - isn't as simple as it sounds.

Having emerged relatively unscathed from the global financial meltdown, the banks were among the biggest beneficiaries of corporate income-tax cuts by Liberal and Tory governments over the past decade.

The case for lowering them further, even during times of austerity, is that Canadian businesses must be competitive with the rest of the world or lose ground. But in the banking sector, the tax debate inevitably becomes a debate over pensions. Since much of the country's pension funds are heavy investors in bank stocks, they depend on ever-higher profits from those financial institutions to increase stock prices and pump out dividends.

Canadian banks pay a lot of tax, but they are also very effective at reducing the taxes they pay. According to the Canadian Bankers Association, about 15 per cent of the industry's profits are taxed in foreign countries where rates are lower. And much of their future expansion - and profit growth - will likely come outside the reach of the taxman in Ottawa.

While bank operations, such as branches, pay taxes in jurisdictions where they are located, other functions can be directed through a bank's foreign offices to take advantage of lower tax rates.

So even if corporate taxes were hiked by Ottawa, not all of a bank's profits would be taxable. The use of low-tax jurisdictions dropped the Canadian bank tax rate by five percentage points across the six biggest lenders in 2009, and increased their after-tax earnings by about 6 per cent, Mr. Reucassel estimates.

All the major banks report tax rates significantly lower than the Canadian statutory rate. In 2009, Toronto Dominion Bank, which draws a large proportion of its profit from the U.S. and other foreign jurisdictions, reported an effective tax rate of 7.6 per cent. (The tax rate paid on TD's Canadian profits is much higher, of course.)

Such efforts to mitigate taxes paid are seen by shareholders and analysts as a positive thing when the financial institutions report their quarterly numbers, since profits and stock prices rise as a result.

This is the crux of the debate: Should the government want to boost corporate income taxes, it would put pressure on bank earnings, and affect the investors - from pensioners to large institutions.

Collectively, those investors pay a lot of tax, too, on the dividends banks pay and on capital gains when they sell their shares. So the revenue the government gained would automatically be lost, in lower personal income taxes.

"Declining corporate tax rates have had a material impact on bank earnings growth, which has driven much higher dividends and dividend growth," said Rob Wessel, managing partner at Hamilton Capital Partners in Toronto.

It's an argument the banks take to Ottawa regularly. In its submission to the House of Commons Standing Committee on Finance in August, the Canadian Bankers Association warned about the impact of increasing corporate income taxes. "As most Canadians are shareholders in Canada's banks either directly or through the Canada Pension Plan, pensions and mutual funds, these payments benefit the vast majority of Canadians and their retirement savings," the lobby group said.

But there are other levers to increase tax revenues, even if a government does not want to push Canada's income tax rates above that of other competing nations. Tightening rules on income reported in foreign tax jurisdictions, one analyst noted, would have a similar effect of increasing tax revenue, because it would mean less income was reported outside Canada. Some analysts wonder if this might be the direction Ottawa heads in.

Either way, the reality facing banks, and other sectors, in the next few years is that the earnings growth they have seen from falling tax rates in the past decade will soon dissipate. Falling corporate income-tax rates that began under the Liberals in 2000 and were continued by the Tories starting in 2006 will settle out in 2013.

Though taxes would remain far lower than they were a decade ago, they would no longer be a catalyst for profit growth, since the rate would hold steady year to year. Mr. Reucassel estimates drops in corporate income-tax rates fuelled as much as a third of the growth in bank earnings over the past decade.

The end of this "tailwind," as he puts it, is a significant factor. If falling taxes help drive earnings growth, the banking sector will have to find a new catalyst somewhere else, whether it faces a new tax headwind or not.

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