Not a sure thing

After Telus announced in September that it was converting to an income trust, there was immediate speculation that BCE wouldn’t be far behind. Many pundits believed it was only a matter of time, despite denials from BCE management. In fact, BCE shares immediately jumped to an 11-month high of $29.68 after the Telus news broke and continued to strengthen thereafter.

Well, it turns out the pundits, and the speculators, were right. Recently, CEO Michael Sabia made headlines by announcing that corporate BCE Inc. will soon die, to be replaced by the Bell Canada Income Fund.

Assuming shareholder approval, the expectation is that the conversion will take place during the first quarter of 2007 at which time each existing share of BCE will be exchangeable for one share of the new income trust. BCE and Bell also plan to make a cash offer to redeem all outstanding preferred shares.

Although obviously not unexpected, official confirmation of the move sent shock waves through the financial community and raised new concerns that the federal government will be forced to move to rein in the trust explosion before it consumes all of corporate Canada. Since he former Liberal government abandoned its efforts to put the trust genie back in the bottle almost a year ago, three major companies have moved to convert (CI Financial was the other). Without doubt, more such plans are being examined in depth in boardrooms across the land.

Clearly, the attempt to make trust conversion less attractive by raising the dividend tax credit has not had the desired effect. There are still huge tax-saving incentives to move from a corporation to an income trust. Telus expects to save $600 million in taxes in 2007 while BCE was projected to pay $800 million to the government in 2008.

Finance Minister Jim Flaherty was non-committal when asked for his reaction to the Bell move, repeating his usual mantra of “we continue to monitor the situation”. Prime Minister Stephen Harper took the same line. But the alarm bells have to be ringing in Ottawa.

In fact, some analysts were speculating the morning after the announcement that the Conservative government might take steps to block the conversion (and perhaps the Telus move as well). It seems unlikely that the Tories would attack the whole trust sector at this time, given the public outcry that followed the attempt by former Finance Minister Ralph Goodale to apply the brakes. With their minority position in Parliament and the probability of an election in 2007, the Tories would undoubtedly prefer to postpone that fight to another day.

But targeted legislation to stop the future conversion of large companies to trusts, perhaps through the application of a special tax, might be feasible without enraging seniors who have come to rely on cash flow from the trust sector. The idea that Ottawa might take such action was raised by a leading analyst in a private briefing after the BCE announcement at which he warned that if it should happen the price of BCE shares would plunge just as quickly as they had risen.

There’s another wrinkle to the plan that is likely to lead to some shareholder dissidence. If the conversion takes place, it will be a taxable event (as will the Telus conversion). That means Canadian investors will be deemed to have sold their BCE shares when they are exchanged for the new income trust units. Any resulting capital gain or loss will have to be reported when their 2007 tax return is filed.

For some people, this could be very expensive. I’ve already heard of one long-time Bell Canada worker who is livid about the situation. He’s been buying BCE stock through an employee purchase plan for years and has accumulated a large holding over that time. He calculates the tax on his capital gains will be equal to almost a full year’s salary!

Despite the adverse tax consequences, the proposed big increase in distributions will probably be more than enough to persuade most shareholders to vote in favour of the move. Currently, BCE pays an annualized dividend of $1.32 a share. That translated into a yield of 4.18 per cent based on the closing price of $31.55 on Oct. 10, the day before the announcement. As a trust, Bell Canada expects to pay out $2.55 per unit annually. Based that same price, the yield would be 8.08 per cent. That’s a strong incentive for a shareholder to vote yes.

This is only the start of what could turn out to be the biggest financial story of the year. Over the next few weeks, expect to hear a lot more complaints from disgruntled shareholders who face a big tax hit and increasing speculation about what the federal government may or may not do. In the end, the conversion will probably go through but it’s not a sure thing. There are still some obstacles to overcome.