Feds train guns on income trusts
Vancouver Island News Group
Mon 03 Oct 2005
Page: 0001

Section: Business Examiner South - News
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Is the income trust gravy train slowing down?

Federal finance minister Ralph Goodale sent a second signal late last month
that this might indeed be the case by vetoing further advance tax rulings on
income trusts.

Earlier in September Goodale had sent his first signal, announcing a
consultation with interested parties on the future of such trusts, of which
there are more than 140 publicly traded, and in which Canadians have invested
more than $170 billion.

Goodale's actions came in the wake of the Royal Bank and CanWest Global
announcing contemplation of converting to trusts.

Cancelling tax rulings (which Revenue Canada provided for a fee) means that
public offerings of new income trusts will no longer be able to guarantee their
new entity will provide the hoped-for tax advantages. Investors will just have
to wait and see if the wizards behind the conversion did their homework on the
rules. And, of course, built in contingencies for rules that may shortly be
changed.

So, what's the appeal of income trusts? Trusts are taxed only on retained
earnings. But this rarely happens. With income trusts, earnings are distributed
entirely as dividends and these are taxed at the appropriate tax rate for each
dividend earner, typically an individual taxpayer.

Explains David Denley of KPMG: "Say a company makes $100 profit. It pays 35
per cent to the federal and provincial governments in tax, then pays $65 to the
investors who pay, say, 31 per cent or another $20 in tax. So $55 out of $100 in
profit ultimately goes to tax. But when a company is sold to an income trust,
the trust pays out all $100 in dividends, and even if the investor pays the top
tax rate, then only $44 goes to tax."

Financial Post columnist Terence Corcoran recently offered a different
example: taxes and inflation reduce the nominal return on bonds-about four per
cent these days-to 0.4 per cent. But income trust units yield eight per cent,
reduced by the same factors to four per cent, a considerable improvement over
bonds.

Goodale has said his primary reason to study income trusts is not fiscal.
Goodale has, however, put the annual loss in federal taxes at $300 million, and
added that one anonymous provincial finance minister has put his (or her)
province's annual loss even higher-at $350 million.

But no, Goodale says he has two other, "as important, if not more important,"
concerns.

"One is the issue of fairness and the other is the long-term implications of
a business vehicle that essentially pulls off revenue stream, leaving little
flexibility for reinvestment for future growth and development."

Denley says there is merit in Goodale's concerns. Income trusts are under
pressure to keep dividends up and the resale value of investment units.

However, Toronto income trust expert Philip Brown argued recently in the
Financial Post that most companies that have recently converted to income trusts
were mature operations with no major investments required. All the conversions
accomplished was to widen the distribution of future profits from a few owners
to many unit holders.

Brown went on to call income trusts an "innovative Canadian solution to a
Canadian problem:" how to grow and operate mid-market companies "that would
otherwise have trouble finding financing for themselves."

Others put it more bluntly: income trusts are uniquely Canadian responses to
Canada's uniquely high corporate tax, itself a disincentive to business
reinvestment. According to a just-released report from the C.D. Howe Institute,
Canada's corporate tax rate is the second highest at 39 per cent of the top 36
industrialized nations'-first is Communist China. The same report cited high
corporate taxes as one of the main obstacles to business growth and attacked as
well high marginal tax rates for low to middle-income earners in Canada.

Income trusts are a kind of flow through entity (FTE) along with Royalty
Trusts and Real Estate Income Trusts-so called because a company's earnings flow
through the trust to investors untaxed. According to Donovan Waters, professor
emeritus from the University of Victoria Law School and counsel to the law firm
of Horne, Coupar, the current boom in income trusts began in the 1980s with
royalty trusts, which were devised to shield oil and gas earnings from corporate
and dividend tax hits.

In the 1990s a new wrinkle was added: the income trust combined with the
limited partnership, another FTE devised to avoid federal restrictions on
investment vehicles putting more than 30 per cent of their funds outside of
Canada.

"Interest rates were so low, bond yields put retirees on fixed incomes in a
very bad place. Investors just jumped into income trusts," Waters says.

Waters too believes Ottawa's concerns about income trusts are warranted. Many
investors see them as an alternative to bonds, but they are inherently riskier.
"There is no guarantee you will get your capital back. What will happen to the
value of the unit if the trust stops paying a dividend? An investor could lose
his shirt."

As well, Waters says, if companies put all their earnings through the trust,
how do they maintain their business?

Ottawa could respond rationally to trusts by reducing the corporate income
tax, thereby reducing the trust's short-term advantage. However, notes Waters,
the Liberal minority government needs the New Democratic Party's support to
survive and the latter has vetoed corporate tax cuts. "It's really very tricky."

How does an ordinary investor get in on income trusts? Any investment house
will arrange it. One can buy a unit in a single company/trust or in several. The
advantage is the steady stream of income-making income trusts especially
attractive to retirees. Those still saving for retirement, however, prefer
direct or mutual fund investment in conventional companies, which are
reinvesting profits and growing in value rather than paying dividends.

Denley speculated that British Columbia might come out ahead on taxes thanks
to income trusts, assuming that most corporations that have converted to income
trusts are based in Ontario or Quebec. While those provincial treasuries lose
corporate taxes, British Columbia's revenues may grow because there are more
dividends being paid out in this province by trusts that were formerly
conventional firms.

B.C. Finance Minister Carole Taylor told the Business Examiner her ministry
was "aware of some questions and we're having a look." She said the government
had to consider both the revenue implications and the impact of trusts on
business growth. "We have to take care they don't disrupt the business climate.
We are watching the whole issue with interest."

By Steve Weatherbe

Business Examiner contributor

[email-masked]

Copyright 2003 businesssouth

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