FINA Committee Report
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TAXING INCOME TRUSTS:
RECONCILABLE OR IRRECONCILABLE DIFFERENCES?
In January and February 2007, the House of Commons Standing Committee on Finance held public hearings on the taxation of income trusts. During our study, the Committee received written submissions and oral presentations from more than 100 groups and individuals representing a wide range of stakeholders. In listening to the presentations made to us, and in reading the submissions made by those who did not appear, we were struck by the range and extent of disagreement among witnesses on a variety of issues.
In this report, the Committee briefly summarizes the submissions and presentations received by us about announcements made by the Minister of Finance and the Department of Finance regarding income trusts. The report also provides our thoughts and recommendations about the range of issues that have arisen since the 31 October 2006 federal announcement regarding the taxation of income trusts.
THE ANNOUNCEMENT ABOUT THE TAXATION OF INCOME TRUSTS
The Distribution Tax
On 31 October 2006, the federal Minister of Finance announced that the government would apply a tax on distributions from publicly traded income trusts or publicly traded partnerships, other than those that only hold passive real estate investments, in order to level the playing field between income trusts and businesses having a traditional corporate structure.
The Minister indicated that the proposed Distribution Tax would apply to certain distributions of income from a flow-through entity beginning in the 2007 taxation year for income trusts starting to trade after 31 October 2006 and beginning in the 2011 taxation year for income trusts already trading on that date. In particular, these distributions would be subject to taxation at corporate income tax rates. Investors in a flow-through entity would be taxed as if the distributions were dividends. The Distribution Tax for flow-through entities beginning to trade after 31 October 2006 would be 34% for 2007, 33.5% for 2008, 33% for 2009 and 32% for 2010; the tax rate for all income trusts would be 31.5% for 2011 and subsequent years.
Since deferred application of the measures announced on 31 October 2006 was conditional on existing specified investment flow-through entities respecting the policy objectives of the federal income trust tax proposal, guidelines on “normal growth” for income trusts and other flow-through entities during the four-year transition period were released by the Department of Finance on 15 December 2006. The Department indicated that it would not recommend any change to the 2011 date in respect of any such entity whose equity capital grows, as a result of issuing new equity, by an amount not exceeding the greater of $50 million and an objective “safe harbour.”
The Department announced that the safe harbour amount would be linked to the value of the flow-through entity’s market capitalization at the end of market trading on 31 October 2006, with reference to issues and outstanding publicly traded units; debt, options or other interests that were convertible into units of the entity would not be included in the value of the market capitalization. Moreover, income trusts could seek permission to grow beyond the proposed limits.
The safe harbour for the 1 November 2006 to 31 December 2007 period would be 40% of the 31 October 2006 market capitalization benchmark, while the safe harbour for each of the years in the 2008 to 2010 period would be 20% of the benchmark; together, growth of up to 100% over the four-year transition period would be allowed. The annual safe harbour amounts would be cumulative, although the $50 million amounts would not be, and new equity would include units and debt convertible into units. Moreover, growth would not include replacing debt that was outstanding on 31 October 2006 with new equity; new, non-convertible debt could be issued without affecting the safe harbour, although the replacement of that new debt with equity would be considered to be growth. Finally, the merger of two or more specified investment flow-through entities — each of which was publicly traded on 31 October 2006 — or a reorganization of such an entity would not be considered to be growth to the extent that there would be no net addition to equity as a result of the merger or reorganization.
Conversions to Corporations
On 15 December 2006, it was also announced that conversions of a specified investment flow-through entity to a corporation would be permitted to occur without any tax consequences for investors.
Consultations on the Draft Legislative Proposals
Draft legislative proposals to implement the proposed Distribution Tax were released by the Department of Finance on 21 December 2006, and it was indicated that constructive comments on the technical aspects of the proposals would be accepted until 31 January 2007.
MEASURING THE TAX LEAKAGE
Witnesses’ General Comments
In his appearance before the Committee, the Minister of Finance spoke about a growing trend towards corporate tax avoidance, with tax avoidance considerations influencing business investment decisions and resulting in gains for non-resident investors at the expense of Canadian taxpayers. In his view, actual and anticipated conversions from a traditional corporate structure to an income trust structure represented a danger to the Canadian tax system and the nation’s economic structure; such conversions are not the way to build a dynamic competitive economy. He also suggested that income trust distributions are being received by a large number of foreign investors who, in his opinion, are experiencing a financial windfall at the expense of Canadian taxpayers and are paying far less in taxes than those paid by income trust unitholders.
Documents provided to the Committee by the Minister indicated support by the provinces of British Columbia, Manitoba, Ontario, Quebec, Prince Edward Island, Nova Scotia, New Brunswick, and Newfoundland and Labrador for the 31 October 2006 announcement regarding the proposed taxation of income trusts and the four-year transition period. The province of Saskatchewan indicated its support for the transition period, while the province of Alberta provided an estimate of its net revenue loss resulting from income trusts.
The Minister informed the Committee that, based on a sound and consistent methodology, a conservative estimate of the federal revenue loss associated with income trusts was about $500 million in 2006. He noted that, in his view, the estimate is similar to that calculated by Professor Jack Mintz of the Rotman School of Management at the University of Toronto.
In speaking about the sensitivity of the estimated federal revenue loss to key assumptions, the Minister indicated that a one percentage point change in the effective federal corporate tax rate from 6.6% to 7.6% would result in an estimated federal revenue loss of $710 million annually. He also noted that the 2006 estimated federal revenue loss of $500 million does not include any conversions by other companies or provincial tax impacts.
According to the Canadian Institute of Chartered Accountants, prior to the 31 October 2006 federal announcement, tax leakage was occurring with respect to the units held by tax-exempt and by non-resident investors. In the Institute’s view, the magnitude of the leakage was growing.
In the view of Ms. Diane Urquhart, the proposal to tax income trusts removes tax advantages. She believed that where there are tax advantages, there are — by definition — government revenue leakages. She suggested that there is a permanent government revenue leakage and a tax-deferred loss associated with Registered Retirement Savings Plans and pension funds. Ms. Urquhart also said that she is prepared to accept the Department of Finance and its expertise, although — in her opinion — the estimated tax leakage is substantially more than $500 million if tax-deferred accounts are considered.
While Mr. Jeffrey Olin expressed his faith in the analysis provided by such persons as Professor Jack Mintz and the Department of Finance, he recognized the existence of other analysis and argued that the question of tax leakage should be considered on a more fundamental and perhaps intuitive basis.
A number of the Committee’s witnesses commented on the methodology and assumptions underlying the Department of Finance’s analysis and estimation of the federal revenue loss — or tax leakage — associated with income trusts. Some witnesses suggested that the actual tax leakage is lower than the estimate provided by the Minister, if a leakage exists at all. In the view of Mr. Don Francis, for example, there is no tax leakage. Similarly, Mr. Cameron Renkas said that studies done by BMO Capital Markets have not shown any tax leakage.
According to Mr. Yves Fortin, the allegation of the existence of a tax leakage is unfounded, and the tax leakage argument is incorrect and unsubstantiated. In his view, the measures contained in the draft legislative proposals — rather than the existence of income trusts — would lead to a loss of tax revenue. He noted that any allegation that income trusts are not taxed is incorrect, since they are taxed at the level of the trust unitholder rather than at the level of the trust. Moreover, he characterized the methodology used by the Department of Finance in its 2005 consultation paper — which the Committee was told has not changed — as faulty. Mr. Gordon Tait suggested that, in his view, some of the assumptions used by the Department of Finance are flawed.
Mr. Tait also told the Committee that income trusts do not reduce government tax revenues. He believed that the tax loss estimates are unlikely to result from differences in cash taxes collected from trust unitholders versus corporations, since — in a cash tax comparison — income trust investors always pay more. He cited three primary reasons for the higher rate of cash taxes in the analysis he conducted: individuals pay taxes at relatively higher marginal and average effective tax rates; cash distributions from a trust form a larger tax base than income from a corporation; and corporations have relatively more ways to shelter income from taxation.
In Mr. Tait’s view, when the burden of taxation is shifted from those that tend to pay the lowest proportion of tax and at lower rates — corporations — to those that tend to pay the highest proportion of tax and at higher rates — individuals — the government would be expected to gain tax revenues. He believed that the government should be indifferent between the payment of taxes indirectly by corporate shareholders and the payment of taxes directly by trust unitholders; in his opinion, investors should decide.
The Canadian Association of Income Funds described the tax leakage estimate as grossly exaggerated and not supported by fact, and indicated that there are no clear, credible data that have been released by the Department of Finance to prove its claim. The Association told the Committee that HDR|HLB Decision Economics Inc. — its independent third-party consultants — agreed with the Department of Finance in 2005 about a methodology, and concluded that there was no federal tax leakage due to the existence of trusts. Moreover, in its view, the federal tax revenues generated from income trusts exceed the revenues that would be generated if these trusts were structured as corporations.
Written submissions to the Committee from individual Canadian investors also indicated a belief that there is no tax leakage. Moreover, the written submission from the iTrust Institute asserted that there is no tax leakage from income trusts and questioned the calculations used to justify the proposed taxation of them.
In the view of HDR|HLB Decision Economics Inc., differing assumptions with respect to four key factors might explain a difference between its analysis and that of the Department of Finance: the effective corporate tax rate for energy trusts; the proportion of income trust units held in tax-exempt accounts; the value of deferred taxes; and the impact of future legislated tax changes. In its view, using exactly the same methodology as the Department of Finance and after making appropriate adjustments to the approach adopted by the Department, the estimated tax leakage is $164 million for 2006 and would be $32 million for 2010.
Witnesses’ Comments on Tax-Exempt Versus Tax-Deferred
In documents provided to the Committee, the Minister of Finance asserted that it is very difficult to estimate future tax revenues from tax-deferred accounts because the timing of pension income, and of withdrawals and annuities from Registered Retirement Savings Plans (RRSPs) or payments out of Registered Retirement Income Funds (RRIFs), is not known. When estimating the impact on fiscal revenues, the federal government takes into account only the current year, and future tax revenues from tax-deferred accounts would be included in revenue estimates for those future years. Consideration of future tax revenues from tax deferred entities would yield a tax revenue gain only to the extent that the projected rate of return on flow-through-entity investments exceeds the rate of return that would have been achieved if those investments had instead been made in other investment vehicles.
HDR|HLB Decision Economics Inc. told the Committee that, in 2005, it worked with the Department of Finance to develop a common methodology and assumptions for deriving tax leakage estimates. The organization and the Department agreed on a general methodology, with one exception: they agreed to disagree on the issue of whether to include the value of deferred taxes. We were informed that while not immediately taxable, distributions received in tax-exempt accounts are taxable on withdrawal and, consequently, have economic value.
According to HDR|HLB Decision Economics Inc., while budgeting is done on a current basis, policy analysis should be done on a life-cycle basis. From this perspective, accounting for the life-cycle effects of deferred taxes is appropriate when changes to tax policy are contemplated.
In the view of the Canadian Association of Income Trust Investors, it is the exclusion of retirement taxes from the Department of Finance’s analysis, rather than income trusts themselves, that is the cause of the tax leakage. Mr. Yves Fortin indicated that the Department considers tax-deferred retirement accounts to be, by far, the most significant source of tax leakage. In his view, tax leakage cannot be attributed to RRSPs and pension funds, even on an annual budgetary basis, since taxable annual withdrawals from such retirement accounts far exceed annual tax-deferred contributions.
Similarly, Mr. Gordon Tait shared his view that the exclusion of taxes paid annually on the income drawn from pension funds, RRSPs and RRIFs — which he characterized as arbitrary — form the basis of the tax leakage argument. According to Mr. Tait and the Canadian Association of Income Funds, only charities and crown corporations are tax-exempt.
Other witnesses, including the Coalition of Canadian Energy Trusts, also noted that retirement accounts are tax-deferred, rather than tax-exempt, while Mr. Tait told the Committee that some analysis does not segregate trusts held inside RRIFs and pension accounts that currently pay tax from those held inside RRSPs, and current taxes collected on trusts held inside all retirement accounts are excluded from estimates. In his view, up to one-third of the trust units held in retirement accounts are in tax-paying accounts.
Regarding taxable accounts that are not tax-deferred, Mr. Fortin indicated that the federal government collects more taxes from these income trust investors than would be collected if the trusts operated as corporations. In this case, there is no tax leakage because, as suggested above, the amount of distributions — which occur on a cash flow basis — exceed the net income that would be taxed in the case of corporations. Moreover, the distributions are taxed at personal tax rates that usually exceed the effective tax rate paid by corporations and the rate applicable to dividends. In his view, if trusts reconvert to corporations, both the tax base and the rates of taxation will decline; at the extreme, if all trusts reconvert by 2011, the government could collect 50% of the amount of taxes that are currently paid by non-deferred trust investors.
Witnesses’ Comments on the Energy Sector
The Minister of Finance, in his appearance before the Committee, said that it would be a mistake to exempt the energy sector from the proposed income trust proposal and to provide the sector with a permanent tax holiday. Moreover, he indicated that it is reasonable to expect all sectors of the economy to pay their fair share of taxes.
The Minister also made five additional points: Canada has no intention of mimicking the U.S. tax code; U.S. Master Limited Partnerships (MLPs) are almost exclusively owned by domestic investors, whereas Canadian energy income trusts are, to a considerable extent, foreign owned; structural impediments in U.S. law have the practical effect of limiting the investment of U.S. mutual funds and tax exempts in MLPs; the federal government does not accept that the U.S. MLP rules will provide a tax advantage as compared to Canadian energy trusts; and the value of Canadian publicly traded energy trusts represents about 4% of the market capitalization of the Toronto Stock Exchange and income trusts comprise more than 15% of Canadian oil and gas production, while the total value of U.S. MLPs is less than one-third of 1% of the market capitalization of the New York Stock Exchange and the NASDAQ. Moreover, he told the Committee that, in Canada, foreigners — primarily Americans — own 50% of large Canadian energy trusts and pay a 15% withholding tax; in the United States, MLPs are almost exclusively owned by domestic investors.
In the view of Ms. Diane Urquhart, who informed the Committee about a special shareholder tax that is paid by U.S. investors who own MLPs within their U.S. individual retirement accounts, MLPs are — for the most part — taxed identically to the manner in which Canadian income trusts would be taxed should the 31 October 2006 federal income trust tax proposal become law. She also believed that it is incorrect to argue that MLPs, because of their competitive advantages, would acquire Canadian oil and gas assets as a consequence of the income trust proposal; she expected that the reverse situation would occur.
The Coalition of Canadian Energy Trusts told the Committee that federal and provincial revenues are enhanced by the energy trust structure, with the Coalition’s member trusts generating higher taxes — provincially and federally — in the past five years than would have occurred had they been structured as corporations; there is no firm evidence that tax leakage is occurring from energy trusts. In the Coalition’s view, oil and gas exploration and production companies have historically paid minimal corporate taxes, while distributions from energy trusts generate current personal income taxes from Canadians, additional tax from compounding investment in tax-deferred accounts and a 15-25% withholding tax from non-resident investors.
According to Pengrowth Energy Trust, energy royalty trusts — which were described as a pivotal part of the Canadian oil and gas industry over the past two decades — are fundamentally different from Real Estate Investment Trusts (REITs) and from existing businesses that may have structured themselves as income trusts. In its view, their differences include a long history, substantial ongoing capital requirements in the energy sector and an active business model. It believed that the energy royalty trust structure has promoted growth, been efficient in facilitating the movement of capital within the oil and gas industry, resulted in innovation, enhanced productivity in the ultimate recovery of mature fields and had minimal environmental impacts. It argued that energy trusts are at the forefront of carbon dioxide injection and other technologies that will increase recovery and productivity as well as minimize the environmental impact of the energy industry and the substantial capital requirements of Canada’s mature oil and gas industry in the future.
Moreover, Pengrowth Energy Trust argued that there is no tax leakage associated with energy royalty trusts compared with traditional Canadian oil and gas companies. In its view, the federal government would lose approximately $1 billion annually in tax revenues if energy royalty trusts are forced to convert back to a corporate structure. It also noted the exemption for REITs and energy trusts in the United States, and argued for the grandfathering of Canadian energy royalty trusts.
Witnesses’ Comments on Provincial Tax Implications
In his appearance before the Committee, the Minister of Finance noted the unanimous support by provincial/territorial governments for the 31 October 2006 federal announcement. In the view of these governments, income trusts have had a negative impact on provincial revenues and economies.
From his perspective, the Provincial Treasurer for the Government of Prince Edward Island indicated that, in 2006, the sudden increase in income trust conversions was becoming a threat, recognizing the obligation to manage and protect public finances and the provincial economy as well as to provide public services. He commented on the number, size and types of companies that were becoming — or were proposing to become — income trusts and noted that when a conversion occurs, provincial corporate income taxes are no longer paid to the province(s) in which it operates. Instead, unitholders are taxed provincially in their province of residence; since unitholders tend to reside in larger provinces or outside Canada, there is a detrimental impact on smaller provinces.
Other witnesses also spoke about the impact of the proposed income trust tax regime on provincial/territorial tax revenues. Mr. Yves Fortin told the Committee that the proposed Distribution Tax would be collected by the province where the trust resides, rather than by the province(s) where the unitholders reside, as is now the case. In his view, the consequence of this proposal is that provinces with an active investment community but few or no trusts would lose most of the taxes now collected from trust unitholders.
A similar point was made by the Coalition of Canadian Energy Trusts, which told the Committee that since most Coalition unitholders live outside Alberta — which is where all energy trusts are based — Canadians in all regions of the country share in the distributions paid, with the result that their province of residence benefits from increased tax revenues.
Witnesses’ Comments on the Transition Period
The Minister of Finance, in his appearance before the Committee, indicated that extending the proposed 4-year transition period for existing income trusts — a period of time that he described as fair and reasonable — to 10 years would involve an estimated federal fiscal cost of about $3 billion. Provincial fiscal costs would also occur, with Alberta losing more than $2 billion and Quebec losing hundreds of millions of dollars. In his view, an extension to the transition period would be a policy reversal and would involve getting through the back door a policy change that cannot be obtained through the front door; it would also mean tax unfairness for a longer period of time and would do nothing for some investors who decided to sell their trust units between 1 November 2006 and 30 January 2007. The Minister also indicated that the proposed growth guidelines for existing income trusts during this transition period are generous. Moreover, we were informed that the transition period in Australia was three years.
The Department informed the Committee that the $3 billion estimate is calculated based on corporate tax rate reductions, including the resource tax rate reductions going from 2006 or 2007 for six years. HDR|HLB Decision Economics Inc. indicated, however, that this result could only be the case assuming unreasonably high growth in income trust distributions over the next several years.
Some witnesses, including Ms. Diane Urquhart, did not support a change to the proposed four-year transition period. She argued that a change would cause a short-term rally in the income trust market, with the result that seniors would increase their involvement in an asset class which she considers to be too risky for them.
In his appearance before the Committee, the Provincial Treasurer for the Government of Prince Edward Island reiterated his support for the proposed four-year transition period for existing income trusts.
Mr. Finn Poschmann characterized the selection of the length of the transition period as an exercise in line drawing and judgment. That being said, however, he believed that the proposed four-year transition period is a reasonable timeframe within which corporations or affected trusts could rearrange their affairs; a longer time period would allow a problem to continue to exist unnecessarily.
The TAMRIS Consultancy told the Committee that it could see no advantage in extending the transition period beyond the proposed four-year period. In its view, income trusts should convert back to a traditional corporate structure as soon as possible.
In its appearance before the Committee, HDR|HLB Decision Economics Inc. calculated an estimated tax leakage of $192 million — $32 million in each year — if the proposed transition period is extended from 4 years to 10 years. In its view, its methodology is identical to that used by the Department of Finance, yet estimates of the cost of such an extension differ sharply; it believed the Department overstates, by a factor of 15, the tax leakage associated with an extension of the proposed transition period to 10 years.
In the view of Mr. Cameron Renkas, a proposed 10-year transition period for Canadian income trusts would have meant a negative market impact of about 8%, rather than 12.5%, and would have saved Canadian investors approximately $10 billion.
Witnesses commented that other countries had a longer transition period when changes were made to the tax treatment of existing publicly traded partnerships, with some noting the 10-year transition period in the United States during which there were no restrictions on partnerships expanding within their existing lines of business or into businesses that generated qualifying income; expansion into a new business that generated non-qualifying income and that was not closely related to the existing business was not allowed to exceed 15% of either gross income or assets.
The Canadian Association of Income Funds told the Committee that future income trust conversions should be limited, thereby implicitly supporting a policy of grandfathering for existing trusts. Mr. Yves Fortin supported criteria and regulations to determine which types of businesses should be, and should not be, allowed to convert to income trusts.
Similarly, Mr. Dave Marshall argued for limits on the creation of new trusts. Mr. Tait, who supported a longer transition period, mentioned that the federal government might have clearly indicated what sectors it believes would be inappropriate for income trust structures, with corporations of a certain size perhaps having to be reviewed prior to conversion.
While advocating an exemption from the proposed income trust tax regime — in essence, grandfathering — as the preferred option, Canada’s Association for the Fifty-Plus said that, at the very least, current income trusts should have a 10-year transition period, consistent with the U.S. approach; this longer period of time would give retail investors a chance to readjust and redirect their investments without panic and perhaps recoup a portion of their losses. Grandfathering was also supported by Mr. Don Francis, who advocated grandfathering of all existing income trusts, without any constraints on their growth, until the 31 October 2006 federal income trust tax proposal is honestly and fully studied.
A 10-year transition period was also supported by Mr. William Barrowclough, who mentioned the decade-long transition period that existed in the United States when similar changes were made in that country.
Written submissions to the Committee from a number of individual Canadian investors also argued that existing income trusts should be grandfathered; the view was also expressed that the 4-year transition period should be extended to 10 years, consistent with the approach taken in other countries. Moreover, it was suggested that a cardinal rule of tax policy is that existing transactions that were in compliance with the previous rules are grandfathered when new adverse measures are introduced.
Witnesses’ Comments on Real Estate Investment Trusts
Regarding Real Estate Investment Trusts, the Minister of Finance told the Committee that, internationally, REITs are treated separately in other jurisdictions that are comparable to Canada. In his view, this separate treatment in other jurisdictions justifies continuing this practice in Canada.
A number of witnesses identified the existence of a lack of clarity regarding the exemption for REITs in the 31 October 2006 federal announcement. The Canadian Association of Income Trust Investors commented on the passive fixed nature of REIT assets and their relative contribution as engines of economic growth and employment as well as their overall strategic importance to Canada.
Written submissions to the Committee from individual Canadian investors referred to the REIT exemption as favouritism, and indicated that it is unfair to allow REITS to prosper and continue unchanged while not granting an exemption to the energy sector. It was argued that REITs — as well as private trusts and private income trusts — should be subject to the proposed income trust tax regime.
The Real Property Association of Canada, in its written submission to the Committee, indicated that it is pleased with the decision to continue to recognize REITs. That being said, it identified four issues requiring resolution: the requirement to have foreign property ownership restrictions; the need to require each company in a REIT ownership group to comply separately with all rules; clarification regarding what constitutes income from property for purposes of REIT exceptions; and the need for continuous compliance.