Goodale’s choice

By stopping tax advance rulings for corporations contemplating converting themselves into income trusts, Finance Minister Ralph Goodale has warned investors that he is ready to change Canada’s course with respect to income trust taxation.

He has not only shaken Bay Street but many investors who have been pulverized by inflation and high taxes on their retirement savings. Rumours are circulating that the Canadian Association for Retirement Persons is preparing a major onslaught, not seen since the mid- 1990s when it forced Paul Martin to drop his plans for converting Old Age Security into the Seniors’ Benefit. Mr. Goodale is in for a heck of battle.

So what is the issue? An income trust has been the market’s response to a glaring problem in the income tax system: Dividend income earned by investors in large- and medium-size corporations on common and preferred equity is more highly taxed under corporate and personal taxes (at an average top federalprovincial rate of 56%) than other sources of income, such as rents, royalties and interest, which are deductible expenses from corporate income (but taxed an average top rate of 46% under the personal income tax). By converting a corporation to a trust or a limited partnership, corporate taxes are bypassed, although the government picks up additional revenues from personal taxes on income trust distributions or limited partnership income.

The overall revenue cost for the federal government is about $300-million, as estimated by Finance Canada for 2004. Including provincial tax losses, the aggregate revenue loss to governments is closer to $500-million. This is pocket change compared with the gargantuan $520-billion budgets of all governments.

Given that income trusts have provided a better return to investors and a lower cost of capital to businesses by eliminating the discriminatory taxation of dividends, why would the government even bother doing anything at all? One legitimate concern is that several companies engaged in income trust conversions are choosing a business structure only for the tax benefits provided to investors. Income trusts need to pay out a significant part of their cash flows as distributions — otherwise, they are subject to a penalty tax on their undistributed taxable income.

Many investors might prefer spending distributions that they receive on consumption or other investments, rather than having corporations make the decision for them. While companies with mature assets with stable cash streams are sensibly converted into income trusts, those income trusts that need to grow their business would find that issuing new securities to the market may be more expensive than if they reinvested their profits in new opportunities, as conventional corporations do. Income trusts are not always the best way to organize a business.

The Finance discussion paper presents three potential tax policies. The first is to re-characterize trust interest deductions as dividends, therefore denying an interest deduction that reduces corporate tax. The second is to tax income trusts and limited partnerships like corporations. And the third is to improve the taxation of shareholder income so that discrimination against dividends is removed.

Denying interest deductions would be ineffective as a general solution since it would be difficult to apply to limited partnerships and many trust arrangements. It might be part of an overall approach to limit the use of leverage to bypass the corporate tax.

Taxing trusts and limited partnerships is theoretically possible but both economically and politically wrong. Some trusts, such as family and personal trusts and many limited partnerships, would need to be exempted since their creation had little to do with corporate conversions. Further, it would be impossible to grandfather existing trusts since they could continue buying up assets. Instead, taxes imposed on trusts and limited partnerships would be phased in, causing devaluation once announced. Most important, increasing taxes on trusts tightens the tax noose around Canada’s business sector. Canada has the second-highest effective tax rate on capital among 36 industrialized and leading developing economies. More taxation will only harm Canada’s productivity.

The only sensible solution is to improve shareholder taxation so that investors are neutral among different forms of business organization. If dividends were taxed similarly to income trust distributions and capital gains, investors would choose business and financing structures for their economic, not their tax, attributes.

So what should be done? Although reducing the personal tax on dividends by increasing the dividend tax credit is one approach, another option is to lower corporate income tax rates from the existing 35% to 20%, which is roughly the small business tax rate. This will not only reduce the incentive to create income trusts but also create a significant advantage for businesses to earn profit in Canada. With an average OECD corporate income tax rate of about 30%, Canada would join several other countries, such as Ireland, Hong Kong and Singapore, with low corporate income tax rates. The fiscal cost of corporate tax rate cuts is substantially abated by multinationals shifting profits from other jurisdictions to Canada, an experience found by low corporate tax regimes.

While increasing the dividend tax credit or corporate tax rate cuts creates a level playing field for shareholders holding taxable assets, the pension plans and RRSP owners would continue to prefer income trusts and limited liability partnerships, which bypass corporate tax without paying any tax on distributions or partnership income. If, however, the dividend tax credit were made refundable so that pension and RRSP owners received a rebate for corporate taxes, these investors would be neutral among corporate, trust and partnership organizations. With refunds, federal and provincial governments would need to ensure that corporate tax has been paid before any amount is rebated.

Revamping shareholder taxation is a major tax reform but well worth the fiscal cost. It would appeal to investors in income trusts and limited partnerships since they wouldn’t be penalized by any tax relief given to dividends. It should also appeal to Mr Goodale, who has his eyes on the next poll.