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
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
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
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
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
Taxing
Income Trusts in a Manner Similar to Corporations
Corporations
pay income tax at about 36% in
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
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
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.
Conclusion
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
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,
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.