How to fix income trusts

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 flowthrough 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.

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.