Strategy

Finance: Now you see it ...

Ladies and gentlemen, fans of collateralized debt obligations and credit default swaps, witness another feat of structured finance magic: the total return swap.

The dealers who brought us the CDOs linked to risky assets such as sub-prime mortgages are using another complicated product to line their tailor-made pockets. It’s the total return swap, designed to help foreigners not pay taxes. But instead of stopping the structured-finance guys from selling their product, perhaps it’s time to just simplify the tax system.

Case in point, the purchase offer for Fording Canadian Coal Trust by Teck Cominco (TSX: TCK), set to close at the end of this month. It demonstrates how foreigners can circumvent the 15% withholding tax — with the help of Canadian-based financial institutions and pension plans.

At the end of September, Fording investors approved Teck’s offer of US$14 billion for the units of Fording it didn’t already own. Teck offered a 7% premium: units that traded at $87.09 the day the offer was made were valued at $93.64 in the deal. Foreigners, however — who accounted for more than half of the total unitholders — would have been subject to a withholding tax at the close of the deal. International hedge funds, for example, who jumped on the deal when it was announced, stood to make 7% on their Fording units, but also to pay a 15% tax on the proceeds. Government would have collected about $1 billion.

But that’s not how things unfolded.

An article in The Globe and Mail on July 31 — two days after the deal was announced — pointed out that Deutsche Bank AG and UBS AG were “offering investors the ability to use so-called total return swaps to avoid having to pay income taxes.” For a fee, these dealers use Canadian branches of their international operations to buy shares from foreign holders in exchange for a derivative contract. As Canadian residents, the dealers don’t pay withholding tax, but make a fee from foreigners who don’t want to pay tax. Then, to fund their position in these units, dealers turn to banks or other third-party lenders — namely, Canadian pension plans — to buy the units. As the Globe article pointed out, “Teck and Fording, however, are counting on investors to approve the bid, in the belief that Canadian pension funds, such as the Ontario Teachers’ Pension Plan and the Canadian Pension Plan Investment Board, will step up and purchase billions of dollars’ worth of stock from tax-exposed investors after the vote on the deal in late September.”

So who’s left to foot the tax bill? The banks are Canadian, so not them. Pension plans don’t pay tax. The foreigners, having swapped their units for a synthetic equity position, aren’t paying tax either.

So what does this all mean? First, it means the government isn’t sucking back revenue from foreigners, since the tax can be legally avoided. Fording probably isn’t an isolated example, as total asset swaps can also be used when a dividend-paying equity is owned by a foreign holder and subject to withholding tax. It’s logical dealers would push this product when similar situations arise. They are simply meeting demand within the constraints of the law.

But from a moral perspective, it does raise the question of whether Canadian banks or pension plans should be allowed to participate in these deals. After all, $1 billion in revenue could help bolster federal social programs or even to fund a tax cut. Teachers’ wouldn’t comment on this issue, nor would the Canada Revenue Agency or the ministry of finance. The Canadian Pension Plan Investment Board didn’t return my call.

Is it worth putting an end to the practice? Maybe. But rather than demanding explanations or adding red tape, here’s a better idea: scrap the withholding tax. Why create an industry to circumvent the rules? Remember the foreign-content limit on RRSPs? Along came the clone fund, and you could invest as much as you wanted in non-Canadian securities, regardless of the ceiling limit. Goodbye foreign-content rules. Maybe it’s a leap, but if the ones benefiting from withholding taxes are dealers who sell these tax avoidance schemes, aren’t we better off with a simpler tax system?

Then the structured finance gurus can spend their time addressing the economic crisis. After all, they seem adept at offering solutions to complicated problems.