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Beacon Securities Limited's Submission in Response to Finance Canada's Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships) consultation:

Income Trusts: We Stand On Guard For Most of Thee

The focus of this report is the Department of Finance consultation paper released on September 8, 2005. The paper has been superseded by the decision to increase the dividend tax credit and leave trusts alone for the time being. How-ever, the question what to do with trusts will undoubtedly resurface – probably not long after the January 23 elections.

The Department's paper concerns itself mainly with the charge that trusts reduce federal tax revenues, allegedly by $300 million annually. We conclude that the charge is unfounded. We also briefly examine two other claims made in the paper – one, that trusts enjoy unfair advantages over corporations, and the other, that trusts' high-payout policies may curtail investment. We conclude that it is corporations, not trusts, that enjoy advantages, and that, if investment is com-promised, it is not trusts that will be at fault but rather the financial markets.

The present truce period will provide a window of opportunity for new trusts to come to market. Most of these will not be traditional "corporate trusts," of which we approve. Rather, they will be mainly "trusts on limited partnerships," whereby public corporations and closely-held entities may seek to use trusts in furtherance of their own interests. We view such trusts skeptically. The Canada Revenue Agency (CRA) will be asked to approve them by giving advance tax rulings (ATRs), and provincial securities regulators will need to speak up on the subject of governance.

When the trust discussion heats up after the elections, it will probably involve this very subject – what kinds of trusts should be formed. If actions are taken to restrict the growth of trusts, they will probably concern not the buying but the selling - not the investors but the structures of trusts and the nature of their sponsors. Whereas the discussion of tax revenue and fairness tended to unite trusts, this is an issue that will divide them. We anticipate that our next report, in

addition to our regular work on business and royalty trusts, will deal with this subject.

The Consultation Paper

Part I: On Tax Revenue

Table 1 presents the Department's data in the format of a P&L statement. In the column at the right we show what we believe to be the derivation of the Department's tax numbers. Those numbers are summarized at the bottom of the Trust and Corporation segments. They show $1,205 million taxes for all trusts, plus $40 million in one-time gains taxes from corporations' converting to trusts. The $1,245 million total compares with $1,545 million that the trusts would sup-posedly have generated had they retained their corporate forms, for a net adverse trust tax revenue change of $300 million.

When the data are arranged in P&L format, one fact jumps off the page: the trust model exposes much more of its in-come to taxation than the corporate model does. Corporate income subject to tax can hardly exceed $3,980 million – the figure that reconciles the federal and provincial taxes the Department has given us with statutory tax rates of 22% for federal and 35% for federal-provincial combined. By contrast, the trust model exposes at least its distributions of $8,925 million to tax. We say "at least" because some part of the $2,807 million in undistributed operating income is probably withheld from the distribution simply to maintain a prudent payout ratio. It will probably be distributed in the near future. All told, the trust structure may expose to the taxman $9-11 billion of income, compared with the bare $4 billion of the corporate structure.

Corporate apologists are fond of examples that "suppose" $100 of income is taxed in the corporate model and then alterna-tively in the trust model. They hit the corporate $100 with a big $35 (federal-provincial combined) tax charge, then tax the re-maining $65 again as dividends to shareholders, and cry aloud about the harsh treatment of corporations and their owners. The problem is that $100 on the corporate side is not $100 on the trust side but more like $250 – in the ratio of $4 billion to

$9-11 billion. The big difference in the income subject to tax makes up for the non-taxability of the trust entity.

If trusts expose more income to tax, then why does the federal treasury forego $300 million because of trusts? We do not be-lieve it does. The devil is in the Department's assumptions. In the sections that follow, we discuss five of those assumptions:

(1) Equality of EBITDA, (2) Trusts' distributable cash, (3) Non-resident investors, (4) Corporate capital gains, and (5) Double taxation and the dividend tax credit.

1. Equality of EBITDA 

The Department assumes equality of EBITDA as between income trust and corporation. We think equality of top-line revenue is a fairer assumption. By their cash-conserving nature, trusts are more economical in operating costs than their corporate coun-terparts – lower office rentals, executive salaries, and advertising and promotional expenses, for example. If corporate EBITDA were just 5% less than trust EBITDA, the alleged $300 million federal tax revenue loss from trusts would fall by half to $147 million. Corporate EBITDA would come down 5% to $13,287 million; pretax income, 18% to $3,281 million; federal tax, 18% to $722 million; and the alleged $300 million tax revenue loss, 51% to $147 million.

2. Trusts' Distributable Cash 

As already noted, trusts are in the habit of temporarily retaining a part of distributable cash to keep the payout ratio from ap-proaching 100%. Of the $2,807 million "depreciation and other" in Table 1, suppose $1,000 million were of the nature of a holdback; that would keep the payout ratio at around 90%. Barring a fallback in income and cash flow, that $1,000 million would be slated for early distribution. If 39.5% went to taxable Canadian residents taxed at 25%, federal tax revenues would benefit by nearly $100 million.

3. Non-Resident Investors 

Non-residents are subject only to Canadian withholding tax, which is typically 10% on interest and 15% on corporate dividends and trust distributions. If non-residents had been forbidden to buy Canadian income trusts, unit prices would no doubt be lower, but tax revenues would be higher, for taxable Canadian residents are charged 25% on interest and trust distributions. Canadians get only two relatively minor breaks. One is corporate dividends, which are taxed at 14.6% compared with the non-resident withholding rate of 15%. The other is tax-deferred distributions, where non-residents are subject to immediate 15% withholding.

If non-residents were replaced by taxable Canadians, federal tax revenues would gain $204 million on the trust side and $127 million on the corporate side, for a net change of around $80 million in favor of trusts. The "disadvantage" of foreign owner-ship should never have been charged against trusts in the first place. It is a function not of the trust structure but of tax treaties and the fact that trusts simply pay out so much more than corporations.

4. Corporate Capital Gains 

This is the most important, and easily the most overlooked, of the liberties taken by the consultation paper. We have noted that, in the corporate structure, taxable income is only a bare $4 billion out of $14 billion in EBITDA. Instead of granting that corporations are by that standard lightly taxed, the consultation paper turns the argument on its head. It reasons that the cash retained constitutes an increase in the corporation's "net value," triggering notional gains tax at 12.5% on that part of the in-crease attributable to taxable Canadians.

This feature of the paper accounts for a very large $240 million of tax. By assigning it to the corporate side of the ledger, the Department has by fiat created 80% of the net tax revenue loss it ascribes to trust conversions. The argument lacks credibility, disregarding as it does the transactional and monetary factors that mainly determine realized share gains. In our opinion, the argument is so far-fetched as to call into question the objectivity of the entire consultation exercise.

The Department might argue that it takes its cue from the treatment of trusts' tax-deferred distributions. These, however, are very different in character. Non-residents' tax contribution comes immediately from withholding. Taxable residents' contribu-tion is triggered by distributions and will generate eventual tax without a rise in unit prices. In the Department's corporate share model, there is no trigger, and there is a bold implicit assumption of rising share prices.

5. Double Taxation and Dividend Tax Credit (DTC) 

In addition to federal corporate tax of $875 million, shareholders (non-residents and taxable Canadians together) are paying $165 million on dividends of $2,014 million. The combined effective tax rate on $3,980 million of pre-tax income is 26%. This is not so different from the 22% (an average for non-residents and taxable Canadians) that trust unitholders pay on dis-tributions, and it is almost on a par with the 25% that unitholders would pay if they were all taxable Canadians. It will be on a par in future, since the latest rise in DTC will lower shareholders' 26% to 25%. The DTC has little effect on the combined rate because it does not affect either federal corporate tax or the withholding rate applied to non-resident investors. (Incidentally, the higher DTC helps the corporation more than its shareholders. The corporation does not have to finance the credit by pay-ing more tax, and we can imagine corporations' cutting the payout and arguing that, with the credit, it is unchanged.)

So why the big deal about "double taxation?" It sounds like something onerous until one is reminded that corporate divi-dends are a rather small sum – little more than a fifth of distributions to trust unitholders. Even when dividend taxation and corporate taxation are considered together, taxable income is at least $5 billion shy of the income subject to tax in the trust structure. Indeed, double taxation is a smokescreen that obscures just how much operating income and cash flow escapes taxation in the corporate structure.

If $2,014 million of dividends were taxed like trust distributions at a federal rate of 25%, the bill would be just over $500 million. How much credit can taxpayers afford to give for tax paid at the corporate level when corporations have laid out only $875 million on the entire $11 billion of pre-depreciation operating income?


In the context of the alleged $300 million federal tax drain due to trusts, it is difficult to put a value on the double taxation issue. As for the other four points discussed in this section, resolving all of them in favor of trusts would put $570 million revenue onto the trust side of the scales: $150, $100, $80, and $240 million. In other words, a trust $300 million debit bal-ance might be transformed into a credit of like size.

So trusts have probably not diminished tax revenues after all, and they cannot be accused of having been "unfair" to corporations.

Part II: On Markets

The next issue the paper raises concerns the financing of investment. In a surprisingly strong and authoritarian statement, the authors declare that "distribution of cash flows to investors may not result in efficiency gains if shareholders do not have perfect information on which to make investment decisions." The next sentence seems just as strongly opposed to the work-ings of the market: "The cost of returning to the capital market with secondary (sic) offerings could also be more costly than funding growth through retained earnings."

Shareholders may not have perfect information, but corporate managers may not have it either, especially on broader mat-ters affecting the industry and the economy. Of course it is expensive to conduct public offerings, but investments vetted and justified in this way are likely to be sounder than those made simply because the investor has the cash on hand to finance them.

Markets do not function well if a government authority is prepared to override them; if power is concentrated in the hands of a few big players who exert an undue influence; and if the public, knowing these constraints, displays apathy. All these limitations are evident in the income trust discussion. The Department has released a document that is concerned more with advocacy of the corporate side than with consultation. The nation's largest financial institutions have been curiously silent in the debate, perhaps because their broad involvement with both trusts and corporate equities – as lenders, underwriters, brokers, and fund managers – makes them both conflicted and hedged as to the outcome. Not surprisingly, the public reaction has consisted of apathy, resignation, and occasional lament about the fate of small uni-tholders, but not much study and discussion. It is doubtful that many have actually read the consultation paper, and probably only a handful have read the last footnote on the next-to-last page that sets forth what should be the highly con-troversial estimate of corporate capital gains taxes.

If there is a problem with markets, the Department has not helped matters by openly favoring corporate retentions over trust payouts, or by questioning the quality of information on which market participants act. To have issued a consulta-tion paper and then acted without deigning to consult has not been helpful to the free exchange of opinions on which the market's functioning depends.

There is another way in which the Department has intruded upon the market and impeded its functioning. We refer to the issue of advance income tax rulings (ATR's) in connection with trust conversions.

Part III: On Advance Income Tax Rulings (ATR's)

ATR's were little known to the investing public until they were briefly suspended in November while the consultation paper was airing. The sponsors of a trust wish to avoid a possible claim by the CRA that the launch is a taxable event. The CRA undertakes to study the planned structure and, if it is satisfied, issue a clean bill that has the force of law. This is the ATR. The CRA states that it will rule only on tax matters, not on securities matters such as "fair value" or "generally accepted accounting principles." Officially, it does not turn down any requests. If it cannot issue an ATR, it informs the applicant and the request is withdrawn. It reveals the substance of its cases but will not disclose the identity of applicants, citing taxpayer confidentiality.

Most trusts do not require an ATR. In a traditional corporate trust structure, the trust makes a public offering of units, us-ing the proceeds to purchase the shares and new subordinated high-yield debt of an operating corporation. The interest on the debt approximates the corporation's EBITDA, leaving it free of tax. The interest passes through the trust as a distribu-tion to unitholders, in whose hands it is taxed.

If EBITDA grows, it will become larger than interest expense and could give rise to taxation. A solution is to replace the op-erating corporation with an operating trust or LP, hence, a trust-on-trust or trust-on-LP structure. Since trusts and LP's are flow-through entities, the excess income can be flowed to the holding trust and distributed as taxable income to unithold-ers. This structure probably does require an ATR, since property must be transferred from the corporation to the operating trust or LP.

Creative uses have been found for the trust-on-LP structure. A closely-held corporation can seek to write up assets twice, once on transfer to the operating trust and again on sale of a part-interest to the holding trust or fund. The original private owners can control the enterprise with only a minority position, arrange to take additional shares in lieu of taxable distribu-tions, and phase the exchange of their shares for units so as to slow the advent of tax on gains. As before, the transfer of properties between entities probably requires an ATR.

In this way, we believe the tax jurisdiction of the CRA has overlapped the securities jurisdiction of provincial regulators. Asset write-ups on transfers raise the acquisition cost to unitholders and implicate the CRA as grantor of an ATR. The op-portunity for a minority control group to lift the distribution rate, boost the unit price, and then conduct an opportunistic public offering to take itself out would seem to implicate the CRA as well.

We have tried to test the notion that some of the problem trusts – the "busted trusts" – had features that probably required an ATR. Those features would have included cross-border arrangements, leveraged buyouts, and trust-on-LP structures. How-ever, our polling has not obtained meaningful results. We had hoped that those who had no ATR would say so, while those who did have one would fail to respond on grounds of confidentiality. Too many failed to respond for this hope to be fulfilled: 46 replies to 76 requests is not good enough. Not even all those who report not having ATR's can be taken at face value. We believe some were responding in the name of the trust itself, while the ATR request would have been filed by the sponsor or other related party for whom the Fund cannot or will not speak. There is a lack of "perfect information," all right, and this time it is directly traceable to the advance rulings the tax authorities were not legally required to give but gave anyway.

Summary and Recommendations

The salient point seems to be that corporations escape tax on the largest part of their pre-depreciation operating income. By focusing on pretax profit and taxation at that level, corporations and their apologists distract us from the main issue. The al-leged tax drain from trusts, the fairness issue, and the question of whether to finance investment by market issues or retentions all tend to obscure the low level of income to which corporate tax rates apply.

Corporations derive their economic and political power from the retention of untaxed profits and cash flow. This is the obsta-cle to "integrating" the tax system. Corporations would no doubt be happy to see their shareholders bear virtually all the tax burden, as in the trust model. However, this would require dividending the cash needed to pay those taxes, and corporations are not inclined to give it up. So it seems we shall have two parallel models – the corporate one that retains cash and taxes the entity and the trust model that distributes cash and taxes unitholders. Clearly the shareholder who disposes of his stock and buys units does not do so for tax advantage. He does it, first, for income and, second, for the more stable capital value that he hopes a yield-based instrument will possess compared with a P/E - based one. When trusts have stumbled, some-times the cause has been exchange rates, or seasonality, or cyclicality. More often than not, however, the problem has lain with the sponsors, who went for a higher issue price supported by a higher payout than could be sustained.

Each model is entitled to a degree of certitude. Trusts, in particular, should be free of spurious charges like tax revenue loss and fairness. Beyond that, the authorities will need to clarify the rules governing how trusts are formed and who shall be al-lowed to buy them.

The question how trusts are formed can be divided into three topics: traditional corporate trusts; trusts on LP's; and ATR's. At one end, we favor the unfettered creation of corporate trusts. At the other, we would like to see the granting of ATR's termi-nated. We have a mixed view of trusts on LP's. If the trust owns the operating LP and the purpose of the arrangement is to minimize tax while allowing for growth, we have no objection. If, however, the operating LP is part-owned by an outside or re-tained-interest party who can make self-interested decisions that harm the trust, we do not approve. In fact, if it is not possi-ble to ban this kind of trust without also sacrificing the tax-minimization trust, then we are prepared to see all LP-type trusts excluded. We recognize that many of these matters have a regulatory content, and that their resolution will have to be worked out jointly between the CRA and provincial securities regulators.

On the ownership side, we hope that purchase of units by real persons will not be impeded. By "real persons" we mean indi-viduals and their RRSP accounts. Mutual funds and pension funds deserve less consideration, since they are not real per-sons. Because these institutions are so much larger than individual accounts, their trading activity probably destabilizes the market rather than adds liquidity. Our attitude toward pension funds would be more sympathetic if they did not seek to work both sides of the market, joining with venture capitalists to sponsor trust issues while lining up with individual investors to buy them. Finally, if it is decided that certain investors should be barred from owning units, non-residents and tax-exempt Cana-dian institutions seem the most likely candidates. Insofar as trusts attempt to "integrate" the tax system by letting tax be paid by beneficial owners, tax-exempt investors obviously do not qualify.

Table 1 – Department of Finance Models - Trust and Corporation In P&L Format


$ Millions % of Ebitda Derivations, estimated

TRUST
EBITDA 13,986 100
Interest expense 2,254 16
Income before DD&A 11,732 84
Some DD&A and other ? 2,807 20
Distributions 8,925 64
Tax on interest – third party 205 NR: 2,254 x 0.29 x 0.10 = 65 
CAN: 2,254 x 0.25 x 0.25 = 140
Tax on interest distributed 760 NR: 8,925 x 0.66 x 0.214 x 0.15 = 185
CAN: 8,925 x 0.66 x 0.395 x 0.25 = 575
Tax on dividends 30 NR: 8,925 x 0.037 x 0.214 x 0.15 = 11
CAN: 8,925 x 0.037 x 0.395 x 0.146 = 19
Tax on tax-deferred distributions 210 NR: 8,925 x 0.304 x 0.214 x 0.15 = 85
CAN: 8,925 x 0.304 x 0.395 x 0.125 = 125 (134?)
Total above 1,205
Tax arising on trust conver-sions 40
Total tax 1,245
CORPORATION
EBITDA 13,986 100
Interest expense 2,923 21
Income before DD&A 11,063 79
DD&A and other ? 7,083 51
Pretax income – approximate 3,980 28
Federal corporate tax 875 6
Provincial corporate tax 458 3
Total corporate tax 1,333 9
After-tax income 2,647 19
Dividends 2,014 14
Retained earnings 633 5
Tax on interest – third party 265 NR: 2,923 x 0.29 x 0.10 = 85
CAN: 2,923 x 0.25 x 0.25 = 180
Tax on dividends 165 NR: 2,014 x 0.214 x 0.15 = 65 
CAN: 2,014 x 0.395 x 0.146 = 100 (116?)
Tax on capital gains 240 CAN: 4,909 x 0.395 x 0.125 = 240
Federal corporate tax 875 As above
Total tax 1,545

Notes: NR = Non-residents; CAN = taxable Canadians

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All information contained herein has been collected and compiled by Beacon Securities Limited, an independently owned and operated member of the IDA. All facts and statistical data have been obtained or ascertained from sources, which we believe to be reliable, but are not warranted as accurate or complete. Beacon Securities analysts have visited the head office of this issuer and viewed its operations in a limited context. The issuer did not pay for or reimburse the analysts for the travel expenses associated with the visit.

All projections and estimates are the expressed opinion of Beacon Securities Limited, and are subject to change without notice. Beacon Securities Limited takes no responsibility for any errors or omissions contained herein, and accepts no legal responsibility for any losses resulting from investment decisions based on the content of this report. From time to time, Beacon Securities Limited and/or their directors or employees may hold positions in the securities mentioned, or provide advisory or underwriting services to the companies mentioned herein. Directors or employees of Beacon Securi-ties Limited may serve as directors of any company mentioned herein, or any of their affiliates and subsidiaries.

This report is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell secu-rities discussed herein. Based on their volatility, income structure, or eligibility for sale, the securities mentioned herein may not be suitable or available for all investors in all countries. Any questions and concerns can be directed to David Bodenberg, at (250) 388-0248 or dbodenberg@beaconsecurities.ns.ca.

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