A BCE rebellion?

Let’s not be too quick to assume that the battle for BCE Inc. is over. There is growing opposition to the leveraged buy-out among some of the company’s major stakeholders. Meantime, Telus is sitting on the sidelines, perhaps quietly waiting for the right moment to move in with a hostile counter-offer. The way things are shaping up, such a bid would likely receive a warm reception in many quarters.

It’s been no secret that BCE and Bell bondholders have been extremely unhappy about the way this has all gone down and rightly so. (Disclosure: my wife holds some Bell strips in her registered plan.) The major credit ratings agencies have all issued warnings that the company’s debt securities will be sharply downgraded, probably to junk status, if the plan to finance the takeover by issuing up to $27 billion in new bonds and debentures goes ahead. Predictably, Bell/BCE bonds have plummeted in value.

Most of the bonds are held by institutions but small investors are also being hurt. Here’s one example. It’s an edited version of an e-mail sent to BCE management by one disgruntled bondholder and copied to several media outlets and other organizations. The reference is to Bell Canada 8.875 per cent bonds maturing April 17, 2026.

“A couple of years ago I bought ($30,000 face value) Bell Canada bonds at 130.375. This means the cost was $39,107.10 and the effective yield was 6.8 per cent. I wanted some ‘safe’ corporate bonds in the long end of our fixed-income portion of our holdings. As of July 6 the price is now 105.835 for a paper loss of 19 per cent

“The statements of Bell management that they are creating value for their investors is somewhat disingenuous when the bond holders are considered. Don’t they count too?

“You are pushing the Bell Canada longs towards junk status. I cannot even sell them at the moment because Bell is under a ratings review.

“I would strongly advocate that a condition of the deal be that the existing Bell Canada bonds be ranked well above any future debt instruments that the new owners put in place. I believe this is no less than the fiduciary duty of Bell management.” – Roy Chelsom

Recently we got word that several of the major bond-holders are seriously considering taking legal action over the issue, which could throw a very large monkey wrench into the works.

What about the common stock shareholders? Surely they must be thrilled by the whole deal, right? After all, they’ve been offered $42.75 for shares that were trading at $25.32 around this time last year. That’s a healthy gain of 69 per cent. Surely, they’re all onside.

Well, maybe not. It’s difficult to gauge shareholder sentiment with a stock as widely held as BCE but if my e-mail box is any indication there are a lot of people out there who are unhappy and who are prepared to vote against the offer when the time comes. There may be even more once the full implications of the transaction are understood.

The tax consequences of the sale will be onerous for investors who hold their shares in non-registered plans. When the deal closes, they will be paid cash for their stock. The sale will trigger a taxable capital gain, which could be much higher than many people realize. Long-time Bell/BCE shareholders are especially vulnerable. These include people like Ross E., who sent the following e-mail: “I have worked for Bell for 40 years and am now retired. Over these years I have purchased shares through the employee savings plan each year.”

At this point, Ross has a lot of shares and is worried about what all this means to him. He’s not alone; thousands of employees and former employees bought stock through the company’s share purchase plan and they’re now facing a hefty tax bill.

It all goes back to BCE’s spin-off of Nortel to its shareholders back in 2000. When that happened, there was a change to the adjusted cost base (ACB) for the shares of each company. As it happened, we had BCE on our Internet Wealth Builder Recommended List at the time, at a price of $40.95 per share. After the spin-off, the formula for calculating the revised ACB of BCE stock for capital gains purposes produced a figure of $12.61. One share of Nortel was valued at $18.05.

This means that anyone who purchased BCE shares prior to the spin-off will have a very low ACB for determining their capital gains liability when the deal closes. Using a purchase price of $40.95 to illustrate, someone in this position will have to declare a capital gain of $30.14 per share on the sale ($42.75 – $12.61 = $30.14). Half of that, or $15.07, will actually be taxed. For someone with a marginal rate of 40 per cent, that works out to a tax bill of $6.03 per share.

Granted, a shareholder in this position could still walk away with a nice profit. But in some cases, people could end up losing money and still have to pay taxes. During the late 1990s, BCE shares traded at much higher prices than the current takeover bid because of the valuation attributed to its Nortel holdings. In 1999, the trading range was $56.75 on the low end to a high of $136. In 2000, BCE shares traded as high as $200.20 prior to the spin-off.

Of course, anyone who sold Nortel immediately after the spin-off did just fine. But we all know what happened to the folks who held on. Anyone in that situation who has BCE stock should sell enough Nortel to offset the capital gain they’ll have to report. If they originally paid more than about $46 for BCE, they’ll come out with a loss because of Nortel’s big price drop but at least the capital loss created by selling Nortel shares now will offset any capital gain on the BCE shares as a result of the takeover.

Some low to middle-income shareholders who do not have offsetting capital losses could find the takeover has other unexpected consequences. The taxable portion of their capital gains will form part of the net income calculation on the tax return. That’s the amount that is used to calculate eligibility for various tax credits (e.g. GST credit, age credit, spousal credit) as well as to determine liability for the Old Age Security clawback. It could also result in a big one-year increase in quarterly instalment taxes for those who are required to make them.

Taxes aren’t the only thing that is bothering BCE shareholders. Many are wondering how they’ll replace the cash flow the stock provided. BCE pays an annual dividend of $1.46 a share. Anyone who bought the stock at around $25 last year is currently enjoying a yield of about 5.8 per cent. With income trusts winding down in the face of the government’s new tax, it will be difficult to find a tax-effective substitute for that dividend.

All this considered, it seems that the biggest winners out of the whole deal are BCE’s senior managers. The Globe and Mail reported that CEO Michael Sabia will walk away with over $31 million when all is said and done. Of course, he’ll have to pay tax on some of that money like everyone else, but he can afford to hire some top-notch accountants to minimize the bill.

So back to Telus. An offer from Bell’s western competitor that is partially financed with equity could be appealing to many of the stakeholders. Bond holders would like it because it would mean less debt and reduce or eliminate the risk of a rating downgrade. Some shareholders would favour it because a partial stock rollover would reduce their exposure to capital gains tax and ensure that dividend payments would continue.

Management would fight tooth and nail against such a bid, of course, and the $800 million break fee could make the whole idea uneconomic. But there are a lot of people out there who are hoping that Telus CEO Darren Entwistle and his team aren’t ready to walk away just yet.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm