Business Issues: income trusts (National Post article)

Diane Francis, Financial Post, Published: Saturday, November 05, 2005
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The backlash against any changes to the tax treatment of income trusts is a welcome demonstration of shareholder democracy.

But a thoughtful and equitable solution for the government to consider has been written by Marc Robinson and Ravi Sood with Bay Street money manager Lawrence & Co.

The controversy began when Finance Minister Ralph Goodale announced his department would no longer provide advance tax rulings for income trusts due to "tax leakage" of about $300-million a year. The income trust index plummeted and letter-writing campaigns began.

The Lawrence report defends income trusts, addresses the tax inequities (income trust distributions versus dividends and capital gains) and provides an elegant, compelling solution for everyone.

"Historically, Canadian companies have been subjected to several competitive disadvantages: capital markets that lack depth and liquidity, a paucity of capital for mid-market companies, a disappointing track record of corporate governance and a domestic corporate tax regime that disadvantages Canadian companies compared to their international peers," the report says.

Of the 200 Canadian income trusts, about 70 have a market cap of less than $200-million, Mr. Robinson said in a phone interview yesterday.

The report questions the "leakage" of $300-million a year as stated by Goodale. "Personal income tax paid by Canadians increased by almost 12% in the last year, despite that personal income rose by only 4.5%. Part of this discrepancy results from income trust distributions being taxed as personal income. Had such distributions instead been retained by companies, this income would have been taxed at the lower corporate tax rate, resulting in less tax collected by the government," the authors said.

Tax revenues also increased because of capital gains earned by income trust investors. The trust index outperformed all major North American indexes every year since 2000.

The government received more tax revenue because the income trust sector in Canada has attracted new, U.S. companies to its ranks, thus distributing their cash flow to Canadian unitholders who are, in turn, taxed. "There are currently 16 non-Canadian income trusts that have their head office located in Canada," the report said.

The trust phenomenon has also helped reverse the migration of Canadian companies to U.S. listings, also a net benefit. "At present, there are 40 income trusts with at least 20% of their revenues in the United States. This U.S.-based cash flow is distributed to Canadian unit holders and taxed as income in Canada," said the report.

However, Mr. Robinson said there is tax leakage in terms of foreign investors, who pay withholding taxes of 15% to 25% depending on their residency, compared with 46% taxes paid by high earners in Canada on their income trust distributions.

Tax inequities are also a porblem, which is why pension funds and RRSPs are disproportionately invested in income trusts. For Ottawa, this means income trust distributions are not taxed for years until pensions are distributed or RRSP funds withdrawn.

The report recommends the government level the playing field, taxation wise, concerning income trusts (taxed at 46% for high earners); capital gains (taxed effectively at 51% when corporate taxes are included) and dividends (taxed at 56%).

They say near parity can be reached by lowering the corporate tax rate to 33% from 36%; then lowering the shareholder's tax on dividends from 31% to 23%.

That would mean both capital gains and dividends would be taxed only slightly more than income trusts (48% versus 46%). This would stop marketplace distortions and have other benefits.

"Because the effective tax on dividends and capital gains are on par at 48%, managers should now be indifferent from a taxation perspective between capital reinvestment and declaring dividends and should no longer be motivated to buy back shares for a tax advantage," the report says. "Capital expenditure decisions will be strategic rather than motivated by tax avoidance."

This recommendation would create a dramatic drop in tax revenues, so the report suggests a 5% to 10% tax be collected at source by the income trusts. This would tax foreign investors more fully as well as pension funds. For individuals Lawrence & Co. suggests a tax credit.

"Here's how it would work. If Joe Investor was to get $100 from an income trust, he would only get $90 and a tax credit for $10. So when he filed taxes that year he would get his $10 back if he had taxed income."

- Diane Francis is the recipient of a Shorenstein Fellowship at Harvard University's John F. Kennedy School of Government.

© National Post 2005