Responses from the public consultation on trusts 2005: Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships).

The Department began posting public responses to this consultations initiative on Thursday March 16, 2006. Additional responses will be posted in alphabetical order as soon as they are processed. By the end of 2006, the Department had not yet completed the process as it worked through from letter “a” on to build an alphabetical list of responses.

An independent research and analysis firm, HDR/HLB Decision Economics Inc. prepared a study entitled Tax Revenue Implications of Income Trusts for the Canadian Association of Income Funds.  The study considers the difference between tax loss and money in registered accounts where taxes are delayed but through which income is re-invested. It concludes that thet, using methodology consistent with that of the Department of Finance, but considering re-invested income, income trust tax leakage may total $71 million per annum or approximately 0.2% of Canadian corporate tax revenues. This is far less than the $500-million tax loss that was postulated as part of the Department of Finance Consultation Paper on the Flow-through Entitites,

Bank of Canada Working Paper: Income Trusts: Understanding the Issues, by Michael R. King, Financial Markets Department, Bank of Canada Ottawa, Ontario, Canada K1A 0G9, a 2003 Working Paper was never finished as it was intened to explore issues related to income trusts and finanical markets policy.

The paper abstract: An income trust is an investment vehicle that distributes cash generated by a set of operating assets in a tax-efficient manner. The market capitalization of income trusts has grown rapidly over the past two years, reaching $45 billion at year-end 2002. The sharp rise of income trust valuations, the large supply of new issues, and the complexity of their legal structure have increased scrutiny of this asset class. Because retail investors are the principal owners of income trusts, the author explores whether the cash returns from income trusts are in line with the risks.”

Furthermore, “The structure and valuation of a typical income trust are outlined. The benefits of income trusts and the issues related to investment are elaborated, focusing on legal and regulatory issues, corporate governance, operational issues, and market issues.”

Some journalists have generalized about this document to emphasize risks of the income trust structure and market.  Certainly, the document provided a useful point of reference for beginnign explorations—as a Working Paper—at the time of its publication.

However, reading the paper and talking to its author, it is not clear the extent to which the unfinished exploration has tainted federal policy makers’ views on the income trust market.

After much discussion online, members of TrustInvestror.com voluntarily drafted a response to the Department of Finance Consultation on FTE’s.  There were numerous petitions on the Web. But the TrustInvestor petition to the Department of Financecalled for thoughtful consideration of policy given the news that, subsequent to the Consultation initiation but prior to its conclusion, the Minister of Finance, Ralph Goodale had requested a change in working policy at the Department of Finance.  He had put a stop to preliminary tax rulings desired by companies prior to converting common shares into structured trust structures.  In effect, the Minister had put a stop to income trusts prior to hearing feedback from citizens in the process he had initiated to do so.

REGARDING THE CONSULTATION PAPER:

Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships)

TO Denis Normand, The Department of Finance, Ottawa Ontario trusts-fiducies@fin.gc.ca
With request and permission for publication by the undersigned

COPiED TO:

The Prime Minister of Canada, Paul Martin, martin.p@parl.gc.ca
The Minister of Finance, Mr. Ralph Goodale, rgoodale@fin.gc.ca

[October 1, 2005] Statements by the Finance Minister indicate that the government is considering the imposition of punitive measures on income trusts. These statements have roiled the markets and confused investors. In order to insure a fair tax policy and stable policy regime, we urge the Minister not to impose new taxes or other measures that could damage the vitality and growth of income trusts.

Whether tax revenue is lost due to income trusts is a very complex issue. The Department of Finance claims that $300 million in tax revenues were lost in 2004-05. This claim did not include a forecast of deferred tax collections from income trusts held in retirement plans. Nor does this claim consider foreign capital that has flowed into this sector and generated additional revenue. Even if we assumed the government estimate to be accurate, it represents only 15/100ths of 1 percent (.0015321) of the $195.8-billion in tax revenue reported by the Department as income for that year.

No available data supports the Minister’s contention that distributions made by income trusts harm either trusts or the economy. Rather, the profitable performance and growth of flow-through entities over more than ten years provides dramatic proof that this form of equity is an effective use of capital. A thorough analysis of income trusts’ total effects on the economy is needed before government intervention can be considered prudent.

Canada has created an innovative addition to equity markets in the form of income trusts. They are receiving international recognition and investment as a valuable form of security that offers the public opportunity to participate in the growth of Canadian wealth. They are uniquely accessible, high-yield, asset-backed equities that are priced in the market to reward investors for risk capital.

With their emphasis on ownership of productive assets, profitability and cash flow, many income trusts have enhanced standards of corporate accountability to investors and fiscal discipline by management.

Flow-through entities have revived investor confidence in financial markets while attracting low-cost capital to develop Canadian enterprise. The vitality of these securities is reflected in their growth and increasing value.

As investors in Canadian income trusts, we want to ensure the continued health, competitiveness and growth of our markets and economy.

Our confidence and participation in Canadian financial markets is instrumental to the Canadian government.

WITH REQUEST AND PERMISSION FOR THE DEPARTMENT OF FINANCE TO PUBLISH THIS SUBMISSION INCLUDING THE NAMES AND ADDRESSES OF THE MORE THAN 835 INDIVIDUALS, UNDERSIGNED:

In Budget 2005, the Government of Canada announced it would conduct open and transparent consultations with stakeholders on tax issues related to business income trusts and other flow-through entities (FTEs). The release of Public Consultation Paper: Tax and Other Issues Related to Publicly Listed Flow-through Entitieslaunches these consultations. The purpose of this paper is to promote discussion and third party input on a number of key questions by providing background information on FTEs and related economic efficiency issues, an international comparison, as well as the estimated impact of FTEs on federal tax revenues.

The release of this paper by the Department of Finance Canada launches these consultations. The purpose of this paper is to promote discussion and third party input on a number of key questions by providing background information on FTEs and related economic efficiency issues, an international comparison, as well as the estimated impact of FTEs on federal tax revenues.

FTEs: The Policy Challenge

Trusts and limited partnerships have been used by investors for several decades. In the last 10 years, publicly listed income trusts, and the trust sector more generally, have gained popularity as investment vehicles. Since 2000, this growth has accelerated sharply and appears poised to continue doing so.

The issues for consideration and consultation with respect to FTEs include:

The impact of their tax treatment on how businesses are organized in Canada.
Their impact on federal tax revenues.
The potential role tax-exempt investors (e.g. pension funds) may have in this market.
The impact of FTE tax treatment on the Canadian economy.
What Are FTEs?

FTEs include income trusts and limited partnerships. The use of the term “FTE” in this paper refers to FTEs that are publicly listed on a stock exchange in Canada.[1]

Income trusts, which are governed by provincial laws, are an ownership vehicle for certain assets or businesses and typically raise funds by selling units in the trust to public investors (i.e. unitholders). The unitholders are the beneficiaries of the trust, and their units represent their right to participate in the income and capital of the trust. Income trusts generally invest funds in assets that provide a return to the trust and its beneficiaries based on the cash flow of an underlying business. This return is often achieved through the acquisition by the trust of equity and debt instruments, royalty interests or real properties. There are three primary types of income trusts: business income trusts, energy trusts and real estate investment trusts (REITs). Business income trusts are a more recent development in Canada than energy trusts and REITs, which have existed since the 1980s.

Limited partnerships are formed under provincial laws. These laws require limited partnerships to have one or more general partners, who have unlimited liability for the debts of the partnership. By contrast, the liability of limited partners is generally restricted to the extent of their investment in the limited partnership.

Section 2 provides further details on these types of FTEs.

Growth of FTEs

The market capitalization of FTEs in Canada has grown significantly over the past several years. Total market capitalization was $118.7 billion at the end of 2004, up from $18 billion at the end of 2000. The growth of FTEs has been linked to the low interest rate environment, the attractiveness of the tax treatment of FTEs, investors’ desire for cash distributions, and high commodity (oil and gas) prices.

This growth is likely to continue due to a number of factors. For example:

Alberta, Manitoba and Ontario have recently implemented limited liability legislation, which addresses the concerns of some investors over their potential personal liability resulting from their investments in trusts. Quebec has had such legislation in place since 1994.
Standard & Poor’s has announced that certain income trusts and limited partnerships would be included in the S&P/TSX Composite Index by March 2006.
Section 2 provides further background on factors driving the growth in demand for FTEs.

Tax Policy Implications of FTEs

One of the factors contributing to the growth in the use of FTEs has been the ability of such vehicles to “flow through” income to investors so that income tax is not paid at the entity level. This differs from the tax treatment of corporations and their shareholders, where tax is paid by both the corporation (at the entity level) on its income and by its shareholders when the income is distributed—with some recognition at the shareholder level of the taxes paid at the corporate level. It is important to note that FTEs can also distribute amounts (i.e. return of capital) that are generally taxable upon disposition of the units rather than upon receipt of distributions, which would normally be the case for a dividend paid by a public corporation.

Under Canada’s income tax system, some types of businesses are better suited than others to the FTE structure. For example:

The corporate structure may be more suited for growing businesses (businesses that are not distributing a large proportion of their cash flow as dividends). This is because income retained in the corporation generally bears less tax than if the income is earned at the personal level.
The FTE structure may be more suited for mature businesses. This is because FTEs can distribute cash flows in a manner that achieves full integration of the personal and corporate income tax systems, removing an impediment to distributions.
Section 3 provides more details on the tax policy implications of FTEs.

International Experience With FTEs

This section provides a comparison of the tax treatment of publicly listed investment vehicles in Australia, the United Kingdom and the United States that may be similar to FTEs in Canada. While flow-through tax treatment of certain vehicles exists in these jurisdictions, they are usually more restricted to specific sectors (e.g. real estate and resource properties) than Canada. Canada appears to be in the unique position of having experienced such rapid growth with some of these structures in recent years. The comparison with these countries highlights the fact that the tax system and tax treatment of FTEs varies by jurisdiction; therefore, direct comparisons with Canada are difficult to make.

Section 4 provides further background on the international experience with FTEs.

Tax Revenue Impact

One of the policy considerations with respect to the greater use of FTEs is the impact on tax revenues. It is estimated that federal tax revenues in 2004 were $300 million lower than they would have been if FTEs were structured as corporations. Business income trusts accounted for $120 million of this total, while energy trusts, REITs and limited partnerships accounted for $55 million, $80 million, and $45 million, respectively. These estimates are very sensitive to certain parameters—in particular, the proportion of FTEs held by tax-exempt investors and the average effective corporate income tax rate under the corporate structure.

The estimates in this paper relate only to federal income tax revenues. Provincial tax impacts will depend on where corporations carried on a business prior to converting to an FTE as well as the residence of investors.

Section 5 outlines the estimated impact of FTEs on federal tax revenues.

Economic Efficiency Issues

Given that the tax system may be a factor in the decision as to whether an FTE will be used to structure a particular business, it is important to determine what effect this has on the Canadian economy. Arguments have been made on both sides of this issue: some have argued that the tax treatment of FTEs leads to greater economic efficiency—at least for certain types of businesses—while others have argued that this tax treatment distorts investment decisions and leads to reduced economic efficiency. Economic efficiency issues such as these are an important element of ensuring that Canada maintains a prosperous and secure nation that can offer an unparalleled quality of life.

Section 6 provides further information on the economic efficiency issues related to FTEs.

Potential Policy Approaches

The focus of this paper is to assess the tax and economic efficiency implications of FTEs to determine if the current tax system is appropriate or should be modified. If it is determined that the tax system needs to be modified, the question arises as to the potential policy approaches. Although not an exhaustive list, policy approaches that derive from the discussion of issues in this paper include: limiting the deduction of interest expenses by operating entities, taxing FTEs in a manner similar to corporations, or better integrating the personal and corporate income tax systems.

Section 7 lists some policy approaches that are relevant to the issues identified in this paper.

Budget 2004 Proposals and Stakeholder Reaction

Measures announced in Budget 2004 proposed to limit pension fund investments in business income trusts to 1 per cent of the book value of the fund’s assets. Under the proposed measures, pension funds would also have been limited to holding no more than 5 per cent of any one business income trust. However, on May 18, 2004, in response to stakeholder concerns about the impact of these proposals on pension fund investment, the Minister of Finance suspended the proposals to allow for further consultation.

Budget 2005: Foreign Property Rule Elimination and Commitment to FTE Consultations

Budget 2005 announced the repeal of the foreign property rule (FPR) which, in addition to limiting investment in foreign property by certain tax-exempt entities such as pension funds, registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs), restricted the ownership of limited partnerships by such entities. From a tax policy perspective, limited partnerships have many of the same characteristics as income trusts and raise many of the same policy issues. Therefore, these consultations also include limited partnerships.

Scope of FTE Consultations

Budget 2005 announced that the Government would undertake a consultation process on tax issues related to business income trusts and other FTEs. This paper is being issued by the Department of Finance as background for those consultations. The consultation process will seek input on a number of key questions, including:

Does the tax advantage of FTEs relative to public corporations have a significant impact on how businesses are organized in Canada?

Have FTEs had a significant impact on tax revenues? Is there potential for revenue losses to grow in the years to come?

What impacts are FTEs having on investment decisions and the allocation of capital in Canada? Is the overall impact on the economy positive or negative?
Given the important role that tax-exempt investors play in Canadian capital markets, and could play in the FTE market, what impact could this have on government revenues and economic efficiency?

Overall, are there public policy concerns about FTEs and how the tax system influences their existence, and if so, what actions should be considered to address these concerns?

This process does not include the separate consultations announced on December 6, 2004, regarding the Budget 2004 proposal on mutual funds maintained primarily for the benefit of non-residents.

Consultation Process/Next Steps

The Department of Finance invites submissions until December 31, 2005. An additional vehicle for public input will be symposiums to be organized and hosted by the Canadian Tax Foundation. The Canadian Tax Foundation is an independent non-profit organization devoted to education and research in the fields of taxation and public finance in Canada. The Foundation provides a forum for expert analysis and discussion of issues in these fields, but does not itself advise on or advocate specific policy recommendations to governments. The symposiums are intended to help foster a better understanding and public discussion of the tax and economic policy issues relating to FTEs. The Foundation will provide further information on these symposiums as soon as detailed arrangements have been finalized.

During the consultation process, the Department will continue to monitor developments in the FTE market. Future initiatives, if any, will be taken following these consultations and in full consideration of the costs and benefits related to FTEs.

The document included an annex: Estimated Annual Impact of FTEs on Federal Tax Revenues

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