RESEARCH ARTICLES
OPEN LETTER To Members and Clerk of the Finance Committee
Thank you for helping to make the preliminary study of income trusts happen and allow for public participation. Canadians appreciate the process as some small way to rebuild trust in policy-makers in a situation where it has been terribly broken by tax and equity policy that defied past promises.
The findings of a survey by PricewaterhouseCoopers (PwC) has been released to show that, “A review of Canada’s more than 250 income trusts indicates that trusts have been making an important contribution to the economy, investing their capital and growing their businesses at impressive rates.”
The trusts considered included companies from “sectors as disparate as food products, telecommunications and finance as well as traditional oil and gas royalty trusts and real estate income trusts (REITs).” The clear conclusion is absolutely “counter to the contention of the federal government that income trusts do not reinvest in their business and amount to a long-term dead end for Canadian businesses.”
Mr. Werklund said in a press release that, In a sea of confusion and uncertainty, CCS Income Trust is confident that it is on solid ground. With a history of delivering value to unitholders, a phenomenal growth record and the best third quarter in history, CCS is confident the government’s “Tax Fairness Plan” won’t be derailing its growth plans.
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.
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