Canada: A Modest Proposal (To The Federal Government In Respect Of Income Trusts)

Last Updated: October 13 2005

Article by Simon Romano and John Lorito of Stikeman Elliott LLP (with apologies to Jonathan Swift)

MUCH HAS BEEN WRITTEN of late about the tax treatment of Canadian income trusts, and there is an air of uncertainty afoot. This uncertainty has been caused by the mixed messages coming out of the federal government recently. In light of the important contribution income trusts have made and are continuing to make to both investors’ portfolios and Canada’s capital markets, we thought it useful to contribute our collective four cents to the debate, and at the same time to make some concrete and positive proposals to seek to resolve the uncertainty and set out some clear alternatives for the federal government to consider.

To recap briefly, after backtracking on the subject of pension funds investing in income trusts, the feds promised a consultation paper on the subject. That paper took some time, and was released on September 8, 2005. It was quite neutrally written, and contemplated a comment process ending December 31, 2005. The paper calculated that income trusts had reduced federal tax revenues in 2004 by $300 million, and also raised the issue of whether income trusts encourage economic efficiency or could distort investment decisions and lead to a reduction in economic efficiency. Depending on which anonymous source you listen to, the discussion paper was intended either as (a) a warning that the current income tax treatment of trusts was going to change, or (b) a justification for maintaining the status quo.

Proponents of the likelihood of change noted the $300 million figure Ottawa cited as the tax "leakage" resulting from income trusts, for the year ended December 31, 2004, which could only be expected to increase, especially as stories began to emerge in the media later in the month of September of financial institutions and other large corporate taxpayers contemplating income trust conversions on all or parts of their businesses.

Supporters of the status quo view noted that the $300 million figure (based on approximately $120 billion worth of income trusts, by market capitalization) was de minimis both in the context of annual federal corporate income tax revenues of approximately $30 billion and overall annual federal revenues of over $180 billion. $300 million represents a mere 1% of the former and only about 0.17% of the latter. In addition, some thought that the $300 million figure was likely materially overstated in that it used low rates, including a personal tax rate of 25% federally, compared to the top marginal rate of about 29%, as well as failing to account at all for withdrawals from RRSPs and RRIFs and taxes paid by pensioners. In addition, the estimate ignored the additional tax revenue that is created by investors choosing to invest in a security that provides a regular income stream rather than a common share that may generate taxable income only at the time of sale (i.e. if these were shares of regular corporations then dividends would likely be much lower or non-existent) and from income trust capital gains. From this perspective, the de minimis nature of the overall effect on tax revenues, after about 175 income trusts, showed that the variety of different ways Ottawa taxes Canadians was sufficient to offset any revenue loss concerns.

As for the economic efficiency/productivity arguments, a commonly held wisdom outside of Ottawa is that giving money back to investors to allow them to spend or reinvest it as they see fit must be better than allowing a small number of corporate managers to make these decisions on behalf of investors (especially if it is as a result of a tax bias against corporate distributions). In addition, those following the income trust sector appreciate that it has given medium-sized businesses that used to have little access to capital other than via bank loans the ability to tap the capital markets, and that income trusts have proven to be very dynamic creatures indeed, with many making accretive acquisitions and investments both here and in the U.S., as well as growing organically and increasing jobs. Telling examples of this include Yellow Pages’ acquisition of the SuperPages and the BFI Income Fund’s acquisition of IESI, both of which were rendered possible by the attractive acquisition currency provided by the income trust format. And as for that acquisition currency, it has finally allowed Canadian businesses to avoid the "made in Canada" discount that generally sees shares of Canadian companies trade at a discount to shares of U.S., U.K. and other companies. Income trusts can use their equity as currency on a level playing field with foreign companies without being subject to the higher cost of capital penalty that plagues most Canadian companies.

There is still a place for high-risk growth capital, but many investors, including retirees, that had been burned by the dot-com era (which was, in retrospect, a golden era for poor investment decisions and economic inefficiency in the context of regular corporations!) were looking for higher yielding and more stable homes for their money. It is also somewhat ironic that economic efficiency is being raised as an issue about the time that the C.D. Howe Institute has pointed to Canada’s punitively high rate of tax on investment, and given our capital and employment taxes that discourage both investment and employment growth.

In addition to being very good to investors and our capital markets, income trusts have also, by and large, been very good from a governance perspective. If Enron or Worldcom, among others, had been required to distribute much of their free cash flow on a monthly basis, the accounting high jinks that they engaged in would have been short-lived indeed.

So it was perhaps not at all surprising that the market yawned in response to the discussion paper.

The September Surprise: Advance Tax Rulings Suspended

For some reason (perhaps speculation about banks engaging in income trust conversions, or some confidential tax ruling requests), the feds (or at least the politicians) thought there was a need for another message of some sort. Accordingly, on September 19, 2005, Ralph Goodale, the Minister of Finance, in co-operation with the Minister of National Revenue, announced the suspension of the issuance of advance tax rulings connected with flow-through entities. Again, depending upon which unnamed source is speaking, this was either (a) not intended to send a message, but rather to support the consultation process, or (b) intended to tell the marketplace that Ottawa was serious about changing the treatment of income trusts. The latter message dominated the media in the first few days, and led to a substantial loss of value at some trusts, although of late Minister Goodale has implied that there is no need for fear.

It is not surprising that this somewhat unusual approach, with its ambiguous messages, has caused turmoil and uncertainty in the markets. That is unfortunate, however. We should all think back five or six years. Editorialists and others were bemoaning the "hollowing out" of corporate Canada, our hot young companies were choosing to go public in the U.S. and bypass Canada altogether, and our capital markets seemed to be atrophying. The rise of income trusts, delivering a higher yielding and relatively stable product that Canadian investors wanted, coupled with the excessive regulatory burden on smaller companies coming out of Sarbanes-Oxley legislation in the U.S. and the overall litigiousness of the U.S. marketplace, have collectively saved our capital markets. Rather than stagnating, the robustness of our capital markets over the last several years has become the envy of the world, creating jobs and giving small and mid-sized companies more access to capital than any of us would have ever thought possible. Robust capital markets also have spin-off effects economically, which have been evident over the past few years.

In addition, as noted above, investors have profited very handsomely, and there is now about $170 billion invested in income trusts, with many retirees relying on them to fund their retirement plans.

Where to Now

So let us assume that Ottawa is losing $300 million per year (although, as noted above, this figure may be high), and that this amount will grow, and turn to examine some of the alternatives open to Ottawa, both those set forth in the discussion paper and others. The discussion paper, while acknowledging other possible approaches, puts forth three alternatives for examination, namely: (a) limiting the deduction of interest expenses by operating entities; (b) taxing income trusts in a manner similar to corporations; and (c) better integrating the personal and corporate income tax systems. Let us examine each in turn, as well as other possibilities.

Limiting the Deduction of Interest Expenses

Many operating entities underlying income trusts rely on the deductibility of interest to reduce their tax burden substantially. Accordingly, if the level of interest expense was reduced and capped, they would likely have to pay more income tax. However, corporate operating entities that have grown are in fact paying corporate income tax at normal levels on their growth income. Also, many companies that are not in income trust form also rely on the deductibility of interest to economically justify making investments by reducing their tax burden.

It would be very complex and arguably somewhat unfair to punish income trusts without punishing other highly leveraged businesses, and limiting interest deductibility could reduce businesses’ willingness to invest generally, as it would raise the cost of capital. This is precisely what Ottawa is trying to avoid. In addition, many income trusts, by relying on limited partnership tax flow-through characteristics instead, do not rely on interest deductibility to reduce taxes. Thus, on balance, this seems like a very complex and uneven way to address the small shortfall in tax revenues Ottawa is receiving. This is not to say that it could not occur, just that it seems unlikely.

Taxing Income Trusts in a Manner Similar to Corporations

Corporations pay income tax at about 36% in Canada. Income trusts often pay little or no tax, at least before accounting for growth. If the federal and provincial governments were to impose a 36% tax on income trusts, they would likely have to develop a complex distribution gross-up and tax credit system such as applies to corporate dividends or extend the existing somewhat flawed system to income trust distributions, and they would likely wipe out about a fifth to a third of the overall market value of Canadian income trusts. This is held for the most part by individuals, directly or indirectly through mutual funds and other investment funds. Many of these individuals do not have pension plans and are relying on these investments to fund their retirement plans. They are also voters and contribute to the campaigns of MPs.

In addition to adversely affecting individual investors, such a move would also harm pension plans, thus indirectly hurting both employees and pensioners. This would seem a curious policy choice at a time when most pension plans are generally seriously under-funded.

As well, it would harm the many thousands of employees of Canadian income trusts, by damaging their employers’ growth prospects and access to capital.

Any government that wiped out $35 to $50 billion in market value would probably not be able to get elected again for some time. Accordingly, this does not seem to be a realistic alternative at this time. In addition, it seems unlikely that real estate investment trusts, which are an internationally proven way to hold real estate, would be treated this way, and it also seems unlikely politically that oil and gas trusts would ever be treated this way (recall the furor over the National Energy Program). So such a tax would likely have to focus on the business trusts of central Canada, at a time when there has been much discussion of the "fiscal imbalance" that sees Ottawa take many billions of dollars annually out of Ontario and at a time when the Ontario and Quebec manufacturing base is suffering from high energy prices and the high Canadian dollar. Finally, any proposal to tax trusts of one form or another would likely need to be combined with a limit on interest deductibility (with all of its associated complexity, as described above), otherwise flow-through structures involving trusts and partnerships would simply be replaced, at least for new issuers, with corporate structures that raise leverage to reduce entity level taxation. Four or five years ago, when the income trust sector was relatively nascent, this might have been a practical option. But Ottawa shied away from this proposal in the past.

Better Integrating the Personal and Corporate Income Tax Systems

As the federal discussion paper makes clear, our current tax system punishes dividend recipients, imposing an approximate double taxation penalty of 11 or 12% on them. Other countries, including our neighbours to the south, impose a much lesser tax on dividends. So one option, which would favour corporations that pay dividends, would be to increase the dividend tax credit to avoid this double taxation. But income trusts would still be attractive to investors seeking yield, and to non-taxable investors such as those looking to grow their RRSPs in anticipation of a better retirement. So while this would assist corporations, it would be unlikely to seriously damage the attractiveness or market value of income trusts.

It would however reduce federal government revenues, some have suggested by approximately $1 billion or more annually. So as a solution to the $300 million income trust leakage problem it seems counter-productive, but may be necessary in any event to restore international competitiveness with respect to the treatment of dividends.

No More Income Trusts?

Some have speculated that Ottawa may stop the creation of new income trusts, while grandfathering existing trusts. If that was to occur, it would likely be at best a short term solution. The now preferentially treated trusts would have an unfair competitive advantage over their corporate competitors, and would presumably be able to buy businesses and grow even larger. Thus the impact of income trusts on the economy could well increase nevertheless, and Ottawa would almost assuredly have to act again within a short time to level the playing field.

A Modest Proposal – A Small Tax?

If there is a $300 million annual tax leakage problem, how could that be addressed? This amount was based on about $120 billion worth of income trusts. Let us assume that their annual distributions are at approximately the 8.25% level. That represents $10 billion worth of annual distributions. If a tax rate of 3% were applied to the income trusts making such distributions, that would raise about $300 million annually. If the market capitalization of income trusts were to grow to say $240 billion, their distributions would be expected to rise as well, and thus the extra revenue raised would likely offset any further leakage. This tax would likely reduce the market value of income trusts by about 3%. All in all, a quite modest reduction that might well be politically palatable.

Alternatively, while less attractive because it would (like the existing capital taxes on corporations that are being slowly phased out) bite income trusts without regard to whether they could in fact make distributions, a tax on the equity capital of income trusts could be imposed. Here, a 0.25% annual tax on the $120 billion worth of market capitalization would raise about $300 million annually, and also would likely have about a 3% adverse impact on overall income trust market values. Again, any increase in the number of income trusts would lead to a corresponding increase in their overall tax burden, thus likely avoiding any increasing leakage problem.

If we assume that the $300 million figure is overstated (as described above) by, say, three-fold, and that a more accurate figure is $100 million a year, then the tax rates needed to offset the leakage would similarly be reduced to a 1% distribution tax or a 0.08% capital tax, respectively, and market values would similarly be reduced by only about 1% on average. This would be even more politically palatable. But the question then becomes, why go through the trouble?

Leaving Things Alone – The Status Quo

As noted above, let us assume that there is $300 million in annual federal tax leakage. We would suggest that that is more than offset by the economic spin-off benefits that result from an active and dynamic capital market (including taxes realized on all of the capital gains that have been generated by trusts), and even if not, is in any event a very small drop in the bucket compared to the government’s other revenues. The politics of the status quo would be very attractive. Leaving things alone is a very viable option, and probably on balance the best. The Canadian tax system has many levers and many means of raising revenue, and the overall benefits of income trusts to Canadian investors, Canadian pension plans, small and mid-sized businesses and their employees, and our capital markets, seem to vastly outweigh any minimal tax leakage.


The discussion will no doubt continue. For the reasons discussed above, we believe that any changes that do come about are unlikely to materially adversely affect existing income trusts. Accordingly, we call on Ottawa to make the consultation process as short as possible. We also call on Ottawa to seek to reduce any uncertainty in the interim that has resulted from its recent pronouncements by assuring both Canadian investors and pension plans that they do not need to worry about their portfolios and Canadians that are employed by income trusts that they do not need to worry about their jobs. This will enable our income trusts to get back to the business of creating value for investors and our economy overall.

To paraphrase Jonathan Swift, "It is a melancholy object to those who travel in this country, when they see people filled with worry about trusts." Hopefully, Ottawa will move quickly to dispel these unnecessary worries.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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