Income trusts: Two cheers

The dust has now settled on the Tories’ decision to tax income trusts. The government deserves credit for dealing with this issue even though they had promised to do otherwise. While there is some fury on Bay Street and among some retirees, the reality is that the government and corporate Canada were playing a game of chicken, and at some point the feds would have had to make this decision. In retrospect, it should have been done long ago. There was no economic benefit from income trust conversions, and if anything they created an incentive against capital investment.

This latter argument is probably the one that won the day in Ottawa, rather than the trend towards using income trusts as a means of tax evasion. In the media release and accompanying backgrounder, the Tories are calling this a billion dollar a year tax cut package, something that the media have not really picked up on. The tax loss from income trusts was just over a billion per year according to Jack Mintz, so this package levels the playing field between corporate and income trust governance structures but is still a revenue loss of a billion per year. So much for the government’s spin, lost tax revenues, being the reason for the change.

A cynic might argue that the Tories want to shrink government anyway, but that they would rather take full credit by delivering tax cuts themselves rather than have them built into the system. Another cynic might have stated that this was a good way of changing the topic of discussion, especially after the beating the Tories took from the time they tabled their “clean air” act to the release of the Stern Review on the Economics of Climate Change on Monday.

The plan has several planks, as detailed by Finance Canada:

• A Distribution Tax on distributions from publicly traded income trusts and limited partnerships.
• A reduction in the general corporate income tax rate of one-half percentage point as of January 1, 2011.
• An increase in the Age Credit Amount by $1000 from $4,066 to $5,066 effective January 1, 2006. This will benefit low and middle-income seniors.
• A major positive change in tax policy for pensioners. The government will permit income splitting for pensioners beginning in 2007.

Below is a good summary piece on the income trust package from Jay Bryan of the Montreal Gazette:

We should thank Tories for end of income trust boom

Jay Bryan, Montreal Gazette

Published: Friday, November 03, 2006

MONTREAL – It’s going to be at least a little satisfying to watch the torment visited on members of the Harper government for their undeniably courageous and well-executed about-face on the taxation of income trusts, Canada’s latest destructive investment fad.

Finance Minister Jim Flaherty, who’ll take most of the heat, has done a big favour to Canada’s economy, and we should thank him — even those of us who are smarting today from losses on our income-trust units.

Still, it’s hard to forget that the Tories had a chance to do the right thing a year earlier, but preferred to seize an opportunity for political cheap shots, leaving the hollowing out of Canadian corporations to accelerate in the meantime.

A year ago, Liberals were still clinging to power and musing about creating a level playing field between the trusts and conventional corporations. This produced a temporary drop in the trusts’ value, enabling the Tories to attack mercilessly, portraying any change as an attack on retirees.

The result was a half-measure from the Liberals under which the taxation of dividends from conventional public companies was cut, ostensibly removing the incentive for a taxpaying investor to buy into units of a trust.

(Trusts, unlike corporations, pay little or no corporate tax because they were set up to take advantage of a loophole in tax rules. The supposedly offsetting factor is that owners of trust units pay higher taxes on income from the trust because a break for corporate dividends doesn’t apply.)

The Liberal Band-Aid was a step in the right direction, but ignored the fact any younger investor who wanted to receive trust income tax-free needed only plunk those units into her RRSP. It also did nothing about the fact pension funds are also tax-exempt, and they are big buyers of trust units.

Perhaps worst of all from a standpoint of fairness is that foreign — mainly U.S. — investors are big investors in trust units, by one estimate owning about a fifth of them. With trusts paying no corporate income tax to Canada or to their province of residence, foreigners paid just the tiny 15 per cent withholding tax on investment income that leaves the country.

“One thing I could never understand is why we would want to give a free ride to foreign investors,” wonders Craig Alexander, deputy chief economist at the Toronto-Dominion Bank.

Beyond the tax fairness arguments, though, was a genuine threat to Canada’s economy. Companies were reorganizing themselves as trusts, with very serious disadvantages to Canada and to investors in trust units, for no real reason other than to avoid taxes.

The disadvantage you hear about most often is that since trusts pay no taxes, the loss to federal coffers was approaching $1 billion a year.

As well, trusts only avoid taxation if they pay out substantially all of their profits, so they have less cash available to invest in advanced technology or improved productivity, with unpleasant implications for this country’s future economic growth and standard of living.

But there’s also the risk to trust unitholders themselves. Some iconoclastic members of Canada’s investment community — most of which is made up of firms that have profited hugely from repackaging companies as trusts — have been honest enough to complain that trusts create serious new dangers for investors.

Finn Poschmann, research director at the C.D. Howe Research Institute, agrees. Since a trust isn’t a traditional corporation, it doesn’t have to follow the rules designed to protect shareholders.

Unitholders have less influence over the trust than they would have as shareholders in a corporation and there’s the danger of corrupt inside deals in a trust’s complex web of ownership and control. Annual reports needn’t be nearly as transparent.

Maybe that’s why the Canadian Association of Retired Persons, an association designed to serve older Canadians, actually commended Flaherty Wednesday.

That’s partly because Flaherty softened his policy by delaying the new tax hit for four years. This didn’t prevent trust units from falling, but it cushioned the blow. Flaherty also created valuable new tax breaks for retirees. But it’s also because, as CARP noted, trusts’ high payouts sometimes come “with high risk.”

Many CARP members will still be angry, but it’s better that the trust boom be ended now with a dose of sensible tax policy than in another year or two in a financial scandal and tech-style meltdown.