Banks and insurers are being targeted with new tax measures in the federal budget for the second consecutive year after Ottawa proposed this week to tax shares the financial institutions own in other Canadian companies.

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Federal budget's unexpected dividend tax change would be fresh hit to insurers and banks Back to video

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The largely unexpected tax change could have a “relatively material” earnings impact on Canadian insurers and also hit the country’s banks, according to one analysis.

The budget unveiled by finance minister Chrystia Freeland on March 28 proposes to amend the Income Tax Act to change the tax treatment of these dividends received by financial institutions. While largely tax exempt now, dividends received after 2023 would be treated as business income.

The government said financial institutions have been relying on the “effectively” tax exempt status of these dividends earned on Canadians shares to lower their tax burden, and predicted the new tax treatment would add $3.15 billion to federal revenues over five years, starting in 2024-25.

Paul Holden, an analyst at CIBC Capital Markets, said the budget’s proposal to tax the dividends on Canadian equities at the full tax rate will have the biggest impact on financial institutions of a number of measures introduced by the Liberal government, some of which had been pre-announced.

Based on his team’s analysis, which he said in a note to clients could run high because they did not have access to the proportion of dividend income received from Canadian versus non-Canadian equities, the earnings per share impact from the tax change could be one to two per cent for Canadian insurers.

He noted that insurers’ investment portfolios “typically include a five per cent to 10 per cent allocation to public equities.”

For banks, based on the ones that disclose dividend income, the earnings per share impact of the tax change will be relatively small at less than 0.5 per cent, Holden wrote.

Meny Grauman, an analyst at Scotiabank, said that while the earnings impact will be “relatively modest” for financial services companies he tracks, a more concerning development is the ongoing reliance on the financial sector, which has seen its annual tax burden climb by a combined $2.5 billion over the past two budgets.

“This rising tax burden on Canadian financials clearly points to a less favorable domestic operating environment,” Grauman wrote in a note to clients, adding that large Canadian banks are also dealing with higher minimum capital ratio requirements.

“Although all of these items are small in and of themselves, they should increasingly weigh on valuations as they appear to be becoming a more regular occurrence,” Grauman wrote.

Until now, dividend income from Canadian equities has generally not been taxable for the banks since the companies that pay these dividends do so with after-tax income. Tax law is generally constructed to avoid tax being paid twice on the same funds.

Dividends received by banks and insurers on non-Canadian equities are already treated as business income, in contrast to the treatment of dividends on Canadian equities.

Industry sources suggested that the government will fall short of its revenue target from the proposed tax change because financial institutions are likely to move away from holding stock in Canadian companies due to the higher tax burden.

In his note to clients, Holden said it is probable that insurers will reduce their equity allocations over time.

“This may be particularly true for high-yielding equities where dividends would account for a substantial portion of expected returns,” he wrote.

The latest proposed tax changes signal an ongoing effort by the Liberal government to tap the banking and insurance sectors for new streams of revenue.

In the spring of 2022, Freeland’s budget imposed a one-time 15 per cent tax on their earnings over $1 billion, payable over five years, reasoning that the financial services companies had performed well over the COVID-19 pandemic on the back of government policies that protected their returns. That budget also introduced longer-lasting tax changes for those sectors, including boosting the tax rate on income above $100 million to 16.5 per cent from the 15 per cent levy on other corporations.

The outlook for banks is weaker this year, as tougher economic and financial conditions weigh on their asset quality, growth prospects and funding mix — troubles that were brewing even before the failure of California-based Silicon Valley Bank, which sparked fears about bank stability around the world.

Industry watchers expect insurers, too, may feel some pain from the fallout of the banks failures in the United States, through without deposits and with longer investment horizons, insurers are thought to be facing less potential impact than banks.

The Canadian Bankers Association said it is assessing the implications of the latest budget measures, including the proposed amendments to the tax treatment of dividends financial institutions earn from Canadian corporations.

“Strong banks are a hallmark of our country, and they are key contributors to durable economic growth for all Canadians,” said Mathieu Labrèche, a spokesperson for the industry association, in an emailed statement after the budget was released.

• Email: bshecter@postmedia.com | Twitter: BatPost