How to fix income trusts
National Post
Wed 21 Sep 2005
Page: FP23
Section:
Financial Post: Comment
Byline: Jack M. Mintz, with Duanjie
Chen, Yvan Guillemette and Finn
Poschmann
Source: Special to the Financial
Post

The most important example of financial distortions
caused by the tax system in recent years is the growth of the income trust
market. Income trusts, recently totalling over $140-billion of market
capitalization, have accounted for more than half of all capital financing in
the past several years. This distortion needs to be fixed by improving the
neutrality of the tax system with respect to dividends.

Income derived from equity investments is less highly taxed at the personal
level because investors can claim federal and provincial dividend tax credits
and exclude one-half of capital gains for determining personal income taxes.
Both the dividend tax credit and the capital gains exclusion, however, provide
tax relief in recognition of the taxes already paid at the corporate level. At
present, dividends are taxed more highly than capital gains for upper-income
Canadians -- the top personal tax rate on dividends is about 32% and on capital
gains 23%.

Combined with the general corporate income tax rate of 35%, the effective tax
rate is 56% on dividends and 50% on capital gains derived from undistributed
profits. Other income, such as interest and employment income, is taxed at close
to 46% on average across Canadian provinces.

The effect of these differential tax rates is to distort business financing:

- The high tax rate on dividends will induce businesses to pay income to
investors in the form of interest or other forms of regular income that are
deductible from corporate income.

- When dividends are more highly taxed than capital gains, businesses will
prefer to buy shares back rather than distribute profits as dividends.

Income trusts are another distortion in the system. They are a response by
markets to a tax system that discriminates against dividends, compared with
other sources of income. Income trusts are flow-through entities that are not
subject to tax. The income distributed to unitholders is subject to personal tax
according to the type of income received (dividends, interest or capital gains).
Usually the business operations are highly debt financed, so that most income
distributed to unitholders is interest or leasing income and the company pays
little or no corporate tax.

Many income trusts distribute a large share of their cash flows from
companies that tend to have stable earnings and do not have plans for major
capital spending, hence tax policy creates a bias to finance some types of
investments and not others.

One way to remove distortion is to increase the dividend tax credit. To
improve tax neutrality among different forms of business financing and
organization, the dividend tax credit for publicly traded shares and high-tax
income earned by Canadian-controlled private corporations should be increased to
offset the high corporate income tax rate. Suppose, for example, the corporate
income tax rate were 30% -- roughly the rate that would have applied in 2010 if
the 2005 federal budget corporate tax rate cuts had not been rescinded.

Then, a gross-up of 150% (instead of 125%), a federal tax credit equal to
20%, and a provincial tax credit equal to about 10% would lower the top dividend
tax rate to 24%, roughly equal to the capital gains tax rate.

Some complexity would prevail with added calculations of income pools at the
small business level, but the proposal would benefit small business as well.
Some other adjustments could be considered to ensure that dividends were taxed
at the same rate as other income received by investors. For example, the
dividend tax credit could also be made refundable to pension plans and RRSPs and
a minimum corporate tax on dividend distributions could ensure that dividends
were subject to the corporate tax rate to fund the refundable credit.

These complexities are manageable. The result would be a dividend tax system
that would be neutral and would not favour one form of business organization
over another.

Edition: National
Story Type: Business; Opinion;
Excerpt
Note: From "The 2005 Tax Competitiveness Report: Unleashing the
Canadian Tiger, by Jack M. Mintz, with Duanjie
Chen, Yvan Guillemette and Finn
Poschmann, 2005, C.D. Howe Institute
(www.cdhowe.org), Toronto.
Length: 637 words