Federal budget dividend tax would hit insurers

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An unexpected tax change in the federal budget could have a “relatively material” earnings impact on Canadian insurers and also hit the country’s banks.

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The budget, unveiled by finance minister Chrystia Freeland on March 28, proposes to change the tax treatment of dividends received on Canadian shares held by the financial institutions.

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The proposed amendment to the Income Tax Act would mean dividends received on Canadian shares held by financial institutions after 2023 would be treated as business income. The government said the measure would add $3.15 billion to federal revenues over five years starting in 2024-25.

The government noted that the dividends that would be subject to the new tax treatment are currently “effectively exempt from tax” and that the financial institutions rely on that status to lower their tax burden.

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 the banks and insurers of a number of measures introduced by the Liberal government, some of which had been pre-announced.

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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.

Until now, dividend income from Canadian equities has generally not been taxable for the banks since it is paid out of after-tax income, and tax law is generally constructed to avoid tax being paid twice on the same funds. Dividends from non-Canadian equities, on the other hand, are already taxed as business income.

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Holden said it is probable that insurers will reduce 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 said.

The Liberal government has turned to the banking and insurance sectors for new streams of revenue in two consecutive budgets.

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.

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The outlook for banks is weaker this year, as tougher economic and financial conditions weigh on their asset quality, growth prospects and funding mix — even before concerns over the sector helped sink two banks in the United States and caused a near shot-gun marriage of two former rivals in Europe.

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

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