Exactly three years after the ghoulish release of the fourth version of the notorious "FIE rules", the federal Minister of Finance put his hand into the candy bag of investors with the announcement of a new set of rules to tax so-called "income trusts". These "Halloween Rules" address the Canadian government’s growing concern with the potential loss of tax revenue arising from the use of income trust structures (also known as business trusts) and other types of flow-through entities ("FTEs") as business vehicles instead of traditional corporations.
The proposed measures include the imposition of a new tax on distributions from most publicly traded income trusts and limited partnerships and a reduction in the general corporate income tax rate in order to create a "level playing field" between corporations and income trusts.
The Tax Drain
In simple terms, an income trust is a commercial trust that indirectly owns the assets of an active business. Of special interest to investors (and of special concern to taxation authorities), income trusts (and their subsidiaries) are generally capitalised in a manner that avoids (or substantially eliminates) the imposition of the entity-level tax that normally applies to the business profits of a corporation.
The tax-efficient character of income trusts is well documented and the prevalence of income trusts has grown steadily to reach a market capitalization of approximately $200 billion on the Toronto Stock Exchange, represented by about 250 income trusts in the real estate, oil and gas, telecom, industrial, food processing and manufacturing sectors.1
Several independent studies have attempted to quantify the tax revenue loss resulting from the use of income trusts. In one recent study, the total reduction in federal and provincial taxes was expected to be $700 million for 2005,2 a figure which was expected to rise dramatically following the proposed trust conversions announced by Telus Corp. and BCE Inc. among others.
A Solution In The Making
The federal government has been concerned with the potential loss of tax revenue associated with the tax treatment of income trusts for quite some time. In the spring of 2004, the federal government determined that the potential tax leakage spawned by the expanding use of income trusts needed to be addressed. As a result, the government tabled a number of significant amendments to the Income Tax Act (Canada) in an effort to limit the future loss of tax revenue. In its 2004 budget, the federal government proposed to limit the investments that certain tax-exempt pension funds could make in income trusts.
The proposed amendments would generally have limited the amount that pension funds could have invested in income trusts to 1 percent of the book value of such funds’ assets. In addition, most pension funds would have been prohibited from owning more than 5 percent of any particular income trust. However, in the face of strong criticism from the financial sector, the Canadian government later suspended the implementation of its 2004 budget proposals, pending the completion of "further consultations".
In the 16 months following the suspension of its income trusts proposals, the federal government undertook a lengthy review of the Canadian tax treatment of both income trusts and other types of FTEs, including limited partnerships, culminating in the announcement last November of proposed measures involving a reduction in personal income taxes on dividends in the form of an enhanced gross-up and dividend tax credit regime (the "new gross-up and dividend tax credit rules"). See our bulletin released in November 2005 immediately following the announcement of this regime (click here for November 2005 bulletin). Draft legislation that incorporated the new gross-up and dividend tax credit rules was recently released on October 16, 2006 and has yet to be enacted.
In last year’s bulletin, we noted that the proposals to reduce personal income taxes on dividends did not foreclose the possibility of further legislative changes and that the government could very well consider additional tax changes, such as the imposition of a new additional tax. As previously noted, the new gross-up and dividend tax credit rules only address the investment in income trusts and other types of FTEs by taxable Canadian investors leaving favourable tax treatment on the table for tax-exempt investors and non-residents that invest in income trusts and other types of FTEs.
The Fix – SIFT: The New Tax Acronym
To address these concerns, yesterday’s release introduces a new tax regime for "specified investment flow-throughs" ("SIFTs"). Generally, all publicly traded income trusts will be SIFTs, as will publicly traded partnerships that hold significant investments in Canadian properties. Notably, the government excluded REITs (real estate investment trusts) from being a SIFT, provided the REIT continually satisfies certain conditions.
The general purpose of the new regime is to tax SIFTs more like corporations and to tax their investors more like shareholders. Specifically, the main changes will be to generally tax distributions from SIFTs (other than returns of capital) at a rate equivalent to the prevailing corporate income tax rate (which rate is being reduced by one-half percentage point, to 18.5%, beginning in 2011) and to tax investors on such distributions as though the distributions were dividends.
Currently, the government does not plan on applying the new rules until 2011 to SIFTs (and their investors) that began to be publicly-traded before November 2006. For SIFTs that have not yet begun trading, the new rules will apply beginning in their 2007 taxation year.
More to Come…
This is the first bulletin in a series of tax bulletins addressing these proposed changes. Upcoming bulletins will provide a more detailed analysis of the proposed rules and how they might affect your tax planning decisions.
1. Luann Lasalle "BCE converting Bell Canada into income trust; follows lead of Telus" Canadian Press (11 October 2006).
2. Jack M. Mintz "Income Trust Conversions: Estimated Federal and Provincial Revenue Effects" The Globe and Mail (17 October 2006).
To read Impact Of Income Trust Tax Proposals On Investment Funds In Canada - Part II Of Our Tax Series On The October 31, 2006 Tax Proposals, please Click Here
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
© Copyright 2006 McMillan Binch Mendelsohn LLP