The Canadian government has announced that it will establish a new tax “fairness” plan that promises to institute new taxes on distributions to unit holders from publicly traded income trust and limited partnerships. Unit holder values will be hurt as the commitment to new tax raises the bar for companies hoping to attract capital by delivering returns to investors.

In a news release on Halloween, the Office of the Minister of Finance said that these measures will apply beginning in the 2007 taxation year for income trusts that begin trading after Tuesday November 1, 2006.

Existing income trusts and limited partnerships will be allowed a four-year transition period. That means that existing trusts and partnerships won’t be subject to new taxes until the 2011 taxation year.

Distributions from Real Estate Investment Trusts (REITs) will, apparently, not be taxed in the same way.  So confusion may abound for some time as investors, market experts and policy makers decide what to do with REITs that involve operating service businesses much like business trusts.

To reflect federal and provincial tax rates, trust distributions on companies that convert after the announcement, will be 34 per cent. Existing income trusts and limited liability flow-through units will see a tax on distributions of 31.5 per cent by 2011. This effectively reduces cash flow to investors by more than one third as Ottawa takes its share and brings trusts back into the realm of double taxation by Ottawa. 

Ottawa will pass a 13-percent share of the new tax revenue along to Provinces.

An immediate market sell-off in response to this news is most likely to hit the share values of common equities planning to convert into a trust, such as BCE and Telus. But so too, investors may panic and sell down their income trusts now, rather than waiting to see what comes in the next four years.

With income trusts constituting 10% of the Toronto Stock Exchange market value, all Canadians will feel the pain as Ottawa taxes cash returns before owners are given their responsibility for paying due taxes and given related authority or discretion over reinvestment.

Finance Minister Jim Flaherty positioned his decision as a way to stop a trend towards corporate conversion to create an “Income Trust Economy”. It is something he envisions as deadly in terms of Canadian growth funded by corporate reinvestment.  The difference between Mr. Flaherty’s fear and the income trust reality is that reinvestment can and has been seen an interest of income-oriented investors, large and small, “Bay Street and Main Street”.

The tax win for the government really means that Canadian public markets are, however, not geared to providing investors with income or returns on a tangible and direct basis. From a foreign investor perspective, Canadians and their public markets can not be trusted when political promises are broken and stable policy regimes are discarded for political gain.

While the Canadian economy may be attractive and productive now, and while profitable and growing companies have been structured for public buyers as equities and trusts, the broad economic horizon is no longer as positive four years out if the fair tax intent is turned into rules.

Public returns are going to be taxed before individuals have the chance to pay their fair share of tax.  Tax-avoiding private investments and offshore structures are not going to be diminished by this new policy. Multiplier effects and potential economic benefits of the Canadian public capital market may be stunted as quickly as investors realize the broken relationship between good business and damaged financial markets in Canada.

The new tax promises to transform the TSX initial public offering pipeline from an appealing investor-oriented-returns model back into the realm of pre-tech yester-year, a time remembered by many as a speculation-driven promotional era when public buyers carried the costs of unknown issuers and private risk-laden sell-outs.

That kind of market risk leads to pressure that could well drive financial innovations of benefit to everyone.  But useful innovation likely depends on application of the best principles that have been discovered and developed with experience in the trust market. Over the last 20 years, the flow-through income trust unit was turned from a good idea into a $225-billion Canadian market that returned $20-billion per year to investors. Top managers of widely held firms and closely-held firms that took up the trust structure, talked about the benefits of cash-oriented discipline self-imposed in the trust conversion. 

Then one day later, the world-leading Canadian market and economy pales in the light of tax grabbing policy.

The announcement provides the Conservative minority government some protection against opposition on this issue. But the potential for a two-year window on power has been taken at the cost of ten to twenty cents on the dollar for retirees, pensioners, investors and market issuers from all sides of the market, across Canada and overseas. This happens just at a time when other markets are starting to look at flow-through entities like trusts as a way to attract investments to their productive businesses and build their economies through public investment.

Perhaps with a view towards softening the blow, the government made another small announcement. It said that, as of Jan. 1, 2011, there will be a reduction in the general corporate income tax rate by one-half of one percentage point. And as part of the plan, effective on a retroactive basis back to January 2006, the government will increase the age credit amount from $4,066 to $5,066. The intent is to help low and middle-income seniors along with rules that will allow income splitting for pensioners beginning in 2007.

Please join us in the iTrust Institute, an initiative to temper government policy and inform pending actions with due consideration of investors’ and Canadian economic interests.