Just as little trick or treaters were heading out to try their luck on Halloween evening, Jim Flaherty performed an unexpected trick of his own – he announced the wholesale overhaul of Canada's income and royalty trust market. He tagged publicly traded partnerships for good measure since if that avenue were not closed off, many corporations and trusts could restructure themselves as partnerships and continue the tax saving game. We will refer to affected trusts and partnerships using the Government's catchy new acronym – SIFT – "specified investment flow-through". And we note as an aside that whenever a government official goes out of his way to tell us that something is "fair", we can't help but speculate as to which heads will soon be rolling around on the floor.
The intended effect of the proposal was to finally and truly level the playing field for publicly traded corporations and SIFTs after several unsuccessful attempts, the most recently being the Liberal government's aborted attempt about a year ago. That is, it is intended that all investors, non-residents as well as Canadian residents who are taxable or deferred (pension funds and RRSPs mainly), become indifferent between receiving income from a SIFT or dividends from a corporation.
Many market observers had predicted this kind of legislative amendment, but few thought the minority Conservative government would have the stomach for it. And based on the Liberal government's discussion paper last fall and the Conservatives reaction then, fewer still thought this kind of proposal would ever apply to oil and gas trusts. They had been put in the same category as REITs (real estate investment trusts) which as noted below, were spared the Halloween axe.
It appears that the recent announcement of first Telus and then BCE's proposed conversions, with other large organizations (maybe even a large bank or two) lining up behind them, tipped the Government over the edge. The proposal's grandfathering rules provide relief to existing SIFTs until 2011, as described below, but do nothing for corporations that have announced their conversion but have not been able to get up and trading as SIFTs prior to November 1, 2006, such as Telus and BCE.
However, the Conservatives did learn something from the Liberal misadventure last fall. When the Liberals proposed clipping the SIFTs' wings they were hammered by the seniors lobby. This might be why the biggest chunks of sugar the Conservatives are handing out this Halloween are designed for the elderly sweet tooth. These are an increase in the Age Credit Amount by $1,000 from $4,066 to $5,066 effective January 1, 2006, and income splitting for pensioners beginning in 2007.
Here is the bird's eye view:
- The Federal Government announced some time ago reductions in the corporate tax rate and increases in the dividend tax credit (credit given to shareholders for the tax already paid at the corporate level on the income being paid out as dividends) that would make it so that within a few years, there would be almost no difference between the tax paid on income earned through a publicly traded corporation or SIFT and received by a tax paying Canadian resident. However, RRSPs, pension funds and non-residents still saved large amounts of tax when they received income from a trust instead of a corporation.
- The proposal imposes a tax on the distributions from SIFTs that is designed to apply at the same rate as corporate tax. This tax will be paid by the SIFTs themselves, again mirroring corporate tax.
- The proposal is designed to catch all publicly traded trusts and flow through entities, except REITS (real estate investment trusts) which have special enabling provisions in the Income Tax Act.
- If it becomes apparent that the proposal as it now stands does not catch pretty much the entire publicly traded trust and partnership market (except REITs), the rules will be changed to plug those holes. And if lots of capital starts flowing into existing trusts, new rules may be written to make that situation unattractive. In other words, the Government has sent an explicit message in this regard.
- The tax rate applicable to SIFT distributions will decline from 34% to 31.5% between 2007 and 2011. The average corporate tax rate now is 32%. Hence, any corporations (like Telus and BCE) that decide to proceed with a trust conversion post November 1 will pay a small tax penalty during their first few years, in addition to causing the shareholders to pay a lot of tax on their way into the SIFT category. The Government's objective is clear – no more trust conversions.
- A notional provincial share of this amount (13%) will be collected by the Federal Government and distributed among the provinces on a basis yet to be determined. This will solve a problem some of the provinces have complained about – that trusts have shifted taxation from the producer level (where companies are headquartered) to the investor level (where investors are resident). The Federal Government, it seems, did not want to be accused of instituting a tax "grab" at the expense of the provinces.
- Recipients of SIFT income distributions will be taxed as if they had received dividends. That is, the dividend tax credit will be available in recognition of the SIFT tax paid; the deductibility rules applicable to dividends received by a corporation will apply; RRSPs and pension plans will not have to pay additional tax; and non-residents will be taxed at the withholding rates applicable to dividends. Again, the government is trying to tax SIFTs and corporations in the same fashion and these rules pretty much do it.
- These rules don't apply to SIFT capital distributions, just as they would not apply to a return of capital from a corporation.
- Revenues not distributed by a SIFT will be taxed at the usual trust rate, which is the top individual rate in the province where the SIFT resides. Subsequent distributions of capital would be tax free.
- For SIFTs that began to be publicly traded before November 2006 the proposal will not apply for taxation years that end before 2011, effectively a four year transition period. SIFTs that begin public trading after October 2006 will be subject to the changes announced today for the later of their 2007 taxation year and the taxation year in which they begin to be traded.
Historically, a large part of SIFTs attractiveness has been the tax savings they generate. However, since last fall it has been well known that for taxable Canadian SIFT investors there would be no difference between corporations and SIFTs from a taxation point of view. Nevertheless, this did not slow the market down. This indicates two things. First, the market is driven to an extent by deferred (pension funds and RRSPs) and non-resident investors. And second, investors like the cash flow provided by SIFTs.
The Government's current proposal take the tax advantage out of the equation. However, the commitment to cash flow will remain. Having watched boards of directors wrestle with what it means to convert to a SIFT, we know how significant this issue is. SIFTs are far more dependant on the markets than are most corporations. SIFTs distribute a large percentage of their cash flow, and when they want to make a capital investment they have to go to the market for the capital they need. This causes an interdependence between management and the markets that is unusual. It forces a corporate discipline similar to that engendered by the 1980s junk bonds.
Now we will see how important this SIFT attribute is. We suspect that many well managed SIFTs will continue to thrive. And from now on, a corporation that wishes to compete with the SIFTs in its market can simply announce that it will begin to distribute a competitive percentage of its cash flow. However, managing that trick is not as easy as some might guess.
While many may debate the appropriateness of the SIFT proposals from a tax policy point of view and whether, in the longer term, they will work to the advantage of Canadian capital markets, there would appear to be almost unanimity in the view that the Government should be criticized from two perspectives. First, the Government strongly opposed any changes to SIFT taxation when they were in opposition, which no doubt contributed to the former Government's lack of "intestinal fortitude" and failure to address these issues when the SIFT market was much smaller and tax policy changes would have resulted in far less disruption to the markets. Secondly, the current Government, until yesterday, had sent very clear signals that they did not intend to change SIFT taxation, which any number of taxpayers and businesses relied upon in making investment decisions or decisions to convert into a SIFT. Taxpayers and businesses should be able to rely on such very clear signals from the Government, and are rightly upset that what seemed to be clear Government policy on which they reasonably relied has now been changed abruptly and without warning.
As a further comment, look for the Government to eliminate the 50% ownership restriction on SIFTs. While that was not mentioned in the proposal, this restriction no longer makes sense. If the existing SIFTs are to be encouraged to compete with corporations, they should be given unfettered access to foreign capital markets.
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