Few seemed to care when banks alone were bearing the brunt of politically induced policy paralysis. But now that Ottawa has abandoned its planned corporate tax cuts, bungled the income trust file and blown more hot air about improving securities regulation, the entire financial services industry knows how the banks feel.

The federal Finance Department has had an extraordinary few weeks. On Sept. 8, it released a long-awaited consultation paper on the income trust market. When the industry didn’t react as expected — several firms announced trust conversions, others mused about it, and investors and analysts contemplated every firm’s prospects as a trust — Finance came back 11 days later and announced it would stop issuing advance tax rulings for companies considering conversion to income trusts. While this doesn’t necessarily kill conversions, it has caused some firms, such as CI Fund Management Inc. , to shelve their plans.

One week later, on Sept. 26, Finance said it would not issue bank merger guidelines, which are now years overdue, nor put forward planned corporate tax cuts for fear the government could be defeated on these issues. Later that same week, Ottawa held a meeting about improving securities regulation — to no obvious effect.

The string of procrastinations has many industry people wondering what the feds are up to, and how business is supposed to run effectively in a climate of uncertainty. One industry lawyer likens the government’s recent actions to those of a “banana republic.”

It’s not altogether new. Indeed, the federal government’s first effort to deal with the income trust phenomenon was similarly haphazard. In the 2004 budget, the feds proposed restrictions on pension funds’ ownership of business income trusts. It soon became apparent that Finance hadn’t thought through all the implications of the idea, and it was quickly withdrawn amid an industry outcry. Once again, with the federal government’s decision to stop providing advance tax rulings, it appears to be throwing up a rather indiscriminate roadblock without due thought to the consequences.

Dr. Mark Mullins, executive director of the Vancouver-based Fraser Institute, says it’s important to remember that such decisions leave a mark on the markets: “What the federal government says and what it does has a very real effect on investments and investment intentions.”

Notably, valuations for existing income trusts and prospective trusts dropped sharply with the decision to stop advance tax rulings. The effect of the decision on bank merger guidelines was not nearly as dire as in 1998, when the government killed then-proposed mergers. In fact, this time the negative effect of the continued moratorium on mergers may have been counterbalanced by the sudden gloom around trusts, which analysts suggest may boost the prospects of traditional dividend stocks such as banks.

Mullins is a bit of a skeptic about the trust boom, and suggests that removing the tax arbitrage opportunity between trusts and corporate structures would ultimately be a good thing. However, he notes, it’s also important how the matter is handled.

“The correct resolution is to remove the tax treatment on the corporate side by reducing corporate taxes. It’s not to throw some thoughts arbitrarily into the marketplace with no legislative support nor real indication of direction,” he says.

The banks may have resigned themselves to federal interference, but it has come as a shock to the players in the income trust industry — from issuers and their advisors (such as lawyers and investment bankers) to investors (largely income-hungry retail investors). Already, the Opposition has been relaying complaints from constituents about the possibility that their treasured trusts will have their tax treatment changed, thus negatively affecting their retirement income.

The reaction was evident in testimony from the income trust industry at a Sept. 28 meeting of the Senate standing committee on banking, trade and commerce, and in comments by CI accompanying its decision to defer its possible conversion into a trust.

“This issue has not just affected the many thousands of CI shareholders who have seen close to $1 billion in CI’s market value erased since the announcement, but [it] has also affected hundreds of thousands of ordinary Canadians who have invested in mutual funds that invest in income trusts,” it said. “Since the minister of finance suspended all tax rulings last week, we have received an overwhelming number of calls from shareholders and unitholders very concerned about the negative impact on their investments the government’s announcements have had.”

@page_break@The fear and uncertainty that’s been injected into the market is particularly unwelcome, as there appears to be no good reason for it. The government’s sole justification for the move to stop issuing advance tax rulings appears to be its sense that its consultation paper wasn’t taken seriously enough by the Street. At the Senate hearing, Leonard Farber, general director of legislation in Finance’s tax policy branch, observed: “In the aftermath of the release of the paper, there did not seem to be any attention paid to it.”

Farber added that the department decided that it would be inappropriate for the government to give its blessing to trust conversions when it’s in the midst of a consultation about how to deal with them.

However, if the government was always concerned about the wisdom of issuing tax rulings during a consultation period, then surely it should have announced a halt to advance tax rulings on the same day that it issued the consultation paper.

Instead, firms such as CI announced their conversion plans, only to have them ruined 11 days later. In late September, the firm decided that, despite having done much of the groundwork in preparation for conversion, it would postpone a shareholder vote on the issue until Finance makes clear its plans for trusts.

In doing so, CI CEO Bill Holland said the company could not recommend a trust conversion to shareholders “given the negative business climate created by the federal government. We would hope that the minister of finance lives up to his commitment to provide clarity on this issue at the beginning of 2006, as we are now being forced to operate in a business vacuum.”

“Welcome to our world, Bill,” the big banks’ CEOs must be thinking. They have been operating in their own vacuum since 1998, when the government shot down their last round of proposed mergers. Since then, Finance has promised to produce guidelines for bank mergers. At this point, however, the banks don’t even know what the ground rules are for possible deals, let alone whether they could ever get approval for a transaction — and the government has repeatedly failed to deliver.

The latest delay came when Finance Minister Ralph Goodale issued a statement blaming the move on the Opposition. He reported that earlier this summer he wrote to the finance critics in the three opposition parties “asking whether we can proceed in a serious fashion to deal with the issue of large-scale bank mergers.” After reviewing the responses, Goodale decided “it would not be appropriate to bring forward guidelines on such an important issue in this environment, [in which] it runs the risk of being politicized”.

Of course, the merger question has never been anything other than politicized. If it wasn’t, then Ottawa could simply leave the approval of mergers to bodies such as the Competition Bureau and the banks’ prudential regulator, the Office of the Superintendent of Financial Institutions. Instead, the government has insisted on having its finger in the pie and, as a result, the banks have been left twisting in the wind.

Mullins is puzzled over the feds’ handling of the bank merger question, noting that it can’t simply be attributed to the current minority government position, as the file was handled similarly when the Liberals were in a majority. He says the government keeps being drawn toward facing the question by both industry lobbyists and Finance officials, who believe that big bank mergers and increased domestic competition in financial services would be a good thing. “But then the political reality keeps catching up, and they keep saying ‘no’ to the actual implementation,” Mullins observes. “It may also be timing. If the next election is around the corner, you don’t want to give your opponents a stick to beat you with.”

While the political reality may be that people simply hate banks, Mullins believes “we’re doing ourselves no favours” by inhibiting the growth of banks and protecting them from foreign entrants. He points to the large life insurers as examples of financial firms that aren’t under the same kinds of constraints as the banks and thus have been able to do much more with their capital.

Jack Mintz, president and CEO of the Toronto-based CD Howe Institute, agrees. Bank mergers “could be a win-win in the end if handled properly, since [that] could allow for a more dynamic corporate sector while creating opportunities for greater competition,” he says.

Mergers to achieve economies of scale would need to provide opportunities to increase competition in the domestic market, such as requiring the merging firms to sell branches off to other lenders, Mintz adds: “Now, we have no movement on this issue, and there is no promise that we will get back to majority government after the next election.”

While Ottawa has again punted the bank merger question for fear of the political fallout, planned corporate tax cuts were shelved for much the same reason.

The cuts weren’t scheduled to take effect until 2008 and, Goodale says, there will be plenty of time to reintroduce them. He apparently believes that corporate tax cuts are still important.

“What I have consistently said from the beginning is that these are important to proceed with because they have to do with making sure that investment and jobs continue to happen on the Canadian side of the border,” Goodale told reporters after announcing his decision not to proceed with the move.

Mintz worries that there are more fundamental problems with the Canadian tax system than are captured by either the income trust fiasco or the clampdown on corporate tax cuts. “Income trusts [are] only one of several issues,” he says. “We have higher taxes on dividends relative to capital gains, and that is distorting financial markets as well.
We also have a stalled withholding tax issue, whereby Canadian companies are having difficulty expanding internationally. We also have high taxes on savings, especially for people with modest income.

“It is a mess, and we need tax reform in a major way — not tinkering,” he says, adding that Finance has not yet figured out what it wants to accomplish in that area.

For the time being, such imperatives are going to take a back seat to short-run political considerations. “We have ample time to bring [corporate tax cuts] forward to make sure that they are delivered as promised and on time,” Goodale has said. “And, in the meantime, I’m not going to contribute to destabilizing the House of Commons or causing a premature election.” IE