Setting a fair deal for income trusts

When Canadian tax lawyers first conjured up income trusts in the 1980s, they likely did not mean to skew the tax system — or at least not too much. Nor did the federal tax department when it first approved such trusts. But that is what has happened, especially in the last decade. And now Ottawa, deeply worried about a massive loss of tax income because of the trusts, wants to reform the entire system as early as January. Finance Minister Ralph Goodale says he intends “ to move very quickly” on reforms when a three- month consultation period ends Dec. 31. In September, Goodale froze advance tax rulings for potential trust conversions. The move sent shock waves along Bay Street, and wiped out $23 billion worth of market value of existing trusts as investors bailed out. Now, corporate executives — and private investors both big and small — are worried that the glory days of the business income trusts are over. Income trusts have seen spectacular growth in recent years. They have increased from a market value of $ 1.3 billion in 1995 to $ 170 billion at the end of August. And they are costing the federal treasury lots of money. Income trusts of all kinds cost Ottawa an estimated $300 million a year in “ tax leakage” in 2004. Goodale fears that number could mushroom as more and bigger companies take advantage of the popular tax dodge. The problem for Ottawa is that income trusts pay little or no tax. Instead, they flow their earnings through to unitholders, who are investors such as pension plans or individual Canadians. Because they pay little tax, they are able to pay out dividends that are up to three times as much as other businesses, most of which pay tax. Income trusts first appeared in the 1980s as oil and gas royalty trusts. Then came real estate investment trusts, or REITs. A few years ago, though, a new kind of creature appeared — business trusts. The stock market had just gone through the tech crash, making it difficult for companies to raise money. Trusts were an easier sell to both companies looking to raise capital and investors looking for a tax break. By December 2004, the trickle had become a stampede. Goodale was right when in September he called for a time out to look at income trusts. He saw the problem going beyond lost tax revenue. Income trusts skew the corporate tax system, critics charge. One business pays tax, another does not because it has converted into an income trust. At the same time, trusts can put corporations at a disadvantage when it comes to raising new capital. Given the choice between dividend- paying companies and income trusts, more investors are choosing trusts.

Trusts may even be hurting the economy. That’s because corporations retain most of their profits while trusts pay them out. And trusts don’t reinvest, they don’t spend on research and development and they don’t innovate to enhance productivity. One could argue the cost to taxpayers and the economy is negligible because profits flow through to unitholders, who pay tax and spend the balance. But income trusts are often held in pension funds and RRSPs, where tax is deferred, perhaps for years. Should corporations have to turn themselves into artificial tax shelters to attract investors and raise capital? What will become of the economy if they do? These are valid questions that Goodale must consider when he does respond once the consultations are over. He has no shortage of tools he can use to correct any inequities or blatant unfairness. For example, he could tax income trusts the same way as corporations, or enhance the dividend tax credit to make dividends more attractive to investors. Whatever approach he takes, Goodale must end the uncertainty for investors and executives who feel betrayed by his decision to act after trusts had been operating for years. More important, though, he must set the tax system right so it is fair to all Canadians.