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Manulife expected to take U.S. tax court loss in stride

A pedestrian walks past the Manulife building in downtown Vancouver on May 3, 2012.

JONATHAN HAYWARD/THE CANADIAN PRESS

Manulife Financial Inc. is prepared for the financial hit that followed its U.S. subsidiary's defeat in tax court, according to one analyst.

The insurer's Boston-based business John Hancock Life Insurance Co. faced the U.S. government tax agency, the Internal Revenue Service (IRS), over transactions from several years ago. On Monday, Judge Harry A. Haines said the company's interests do not entitle it to most of its claimed deductions.

This decision represents more than $560-million in U.S. taxes for the company, according to a report by Bloomberg.

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The case is linked to the way insurers such as John Hancock invest customer premiums to produce returns. John Hancock started using "leveraged leases" for some investments more than 30 years ago because this method offered a higher after-tax return than more traditional strategies. A leveraged lease is an arrangement where an investor such as John Hancock teams up with a lender to finance part of the purchase price of assets such as equipment for manufacturing, rail cars and utilities, and then leases them out.

To gain a tax advantage, some of these investments were made in more complex leveraged lease vehicles called lease-in-lease-out (LILO) transactions and sale-in-lease-out (SILO) transactions, for which John Hancock claimed deductions that the IRS has since disallowed. (KPMG LLP has a full breakdown of the issues brought before the tax court.)

The IRS and John Hancock agreed to bring seven of the LILO and SILO transactions before tax court as a test case for all the other transactions.

Interested readers can find the full decision here, but essentially John Hancock was denied its claimed expenses, depreciation and deductions on the LILOs and SILOs. Judge Haines' court found "that in each case the substance of the transaction is not consistent with its form."

Analyst André-Philippe Hardy of RBC Capital Markets said in a note Tuesday that he thinks Manulife had already identified this risk and the earmarked the funds.

"Based on the last disclosure we are aware of, we believe that the remaining risk to Manulife, net of reserves established over a multi-year period, is in the $200-million range," he wrote.

Investors should expect an update from the company on Thursday when the company reports earnings and holds a conference call.

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(Jacqueline Nelson is a Globe and Mail Financial Services Reporter.)

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