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R. Douglas Edmondson'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:

Department of Finance

28 September 2005

Consultations re FTEs, Income Trusts

Dear Department of Finance:

I am writing you at your invitation for submissions on tax and economic efficiency issues Related to Publicly Listed Flow-Through Entities (FTEs) known as Income Trusts and Limited Partnerships. I do so as someone who is an individual investor and a retiree.

Comment on Section 3 -Tax treatment of Public Corporations and Their Shareholders Compared to Tax Treatment of Income Trusts and Their Investors

I wish to comment first in relation to the information presented in the Department of Finance paper in Section 3, Table 3 and Figures 3 and 4. I note that the assumption behind the distribution of $100 dollars of income which will provide a dividend from a Corporation or a distribution from a Trust (Figures 3 and 4 and Table 3 refer) is that 39% of the corporate dividend or of the trust distribution is paid to Taxable Canadian shareholders, while 22% of the dividend or distribution is paid to non-residents and 39% is paid to tax exempt entities such as RRSPs and pension funds.

With this assumption in place, the taxes for a Corporation in Figure 3 on the $100 of income is calculated at both the corporate and personal levels at their respective tax rates for each of the three categories, that is, Taxable Canadians, non-residents and tax exempt entities. The same approach is applied to $100 dollars of income earned by an Income Trust in Figure 4. Finally a comparison between the tax paid by the Corporation and its dividend recipient is made to the tax paid by the Income Trust and its distribution recipient in Table 3. I reproduce Table 3 below, omitting Limited Partnerships since they share many characteristics with Income Trusts, and adding in brackets the combined Federal and Provincial percentage tax rates provided in Figures 3 and 4.

Table 3. Comparison of the Taxes Paid under Different Structures

   Corporate Structure Income Trust

Entity level $35.00 (35%) NIL (0%)
Investor level    
Taxable Canadian $5.70 (22.5%) $14.82 (38%)
Non-resident $2.15 (15%) $3.30 (15%)
Tax-exempt N/A (0%) N/A (0%)
Total tax $42.85 $18.12 (difference $24.73)

In this comparison, no tax is ever paid by tax-exempt entities, ie. The RRSP, RRIF or Pension Fund, even though we know that the taxes on dividends or distributions to a tax exempt entity are only deferred to a later date when they are paid out to the RRSP/RRIF holder or pensioner. Therefore Table 3 fails to reflect the taxes that will actually be paid in the future, and presents both an incomplete and therefore inaccurate total picture of taxes paid. A complete picture is provided in the chart below for when the exact same $25.35 dollar dividend in Figure 3 or $39.00 dollar distribution in Figure 4, that was paid into an RRSP or Pension Fund, is withdrawn from the RRSP or RRIF or is paid out to the Taxable Canadian by his or her Pension Fund and received as ordinary income. The deferred taxes when paid will be:

Taxable Canadian $9.63 (38%) $14.82.(38%)

Table 3 is revised by adding the deferred taxes as seen below.

Revised Table 3. Comparison of the Taxes Paid under Different Structures

  Corporate Structure Income Trust

Entity level $35.00 (35%) NIL (0%)
Investor level    
Taxable Canadian $5.70 (22.5%) $14.82 (38%)
Non-resident $2.15 (15%) $3.30 (15%)
Tax-exempt N/A (0%) N/A   (0%)
Total tax today $42.85 $18.12
Deferred tax paid in future by Taxable Canadian $9.63 (38%) $14.82 (38%)

Total of Tax Today and deferred Tax $52.48 $32.94 (difference $19.54) when paid It is seen than that the difference between Corporate tax paid and Income Trust tax paid is less when deferred taxes are received and taken into account than what the Department of Finance paper Table 3 suggests. To be precise, the total tax under the corporate structure is $ 52.48 not the $42.85 in the Department of Finance Table 3 compared to $32.94 not the $18.12 in the Department of Finance Table 3 under an income trust structure. The implication is that although the total taxes paid under the corporate structure appear to be higher than the total taxes paid under the FTE structure, the tax leakage is not as significant as the Department of Finance paper purports.

Comment on Section 5 - Tax Revenue Implications of FTEs

Table 5 provides the estimated impact of FTE structures on Federal Tax revenues in millions as compared to Corporate Structures in 2004 as well as the Tax paid on conversions from Corporate to FTE structures and taxes on these IPOs. Before making comment, I place Table 5 below followed by the first parameter assumed in the production of these estimates.

Table 5. Estimated Impact on Federal Tax Revenues
($millions, 2004)

Income Trusts Business Energy REITs Limited Partnerships Total

1. Taxes under the FTE structure 420 505 200 80 1,205
2. Taxes under the corporate structure 565 570 285 125 1,545
3. Tax on conversions and IPOs 25 10 5 0 40
Federal revenue impact (1 2 + 3) -120 -55 -80 -45 -300

Sensitivity of Estimates to Key Parameters

These estimates are very sensitive to certain parameters€¹in particular, the proportion of FTEs held by tax-exempt investors and the average effective federal corporate income tax rate under the corporate structure.

The above estimates assume that tax-exempt investors held, on average, 39 per cent of FTEs. However, there is very little data on the proportion of tax-exempt investors holding FTEs.

My first observation is that the Finance Department paper assumes that tax-exempt investors held 39 per cent of all FTEs [Income Trusts or Limited Partnerships] in 2004, even though the paper states very little data exists on the proportion of tax-exempt investors holding FTEs. One can only conclude that an assumption based on very little data lacks the reliability necessary to make valid comparisons between Corporations and FTEs, and that the results in Table 5 are at best guesstimates.

The second observation is that the same key assumption that tax-exempt investors held, on average, 39 per cent of FTEs is used to project the tax revenue impacts under a lesser percentage or greater percentage of FTEs held in relation to different Federal Corporate tax rates. If the assumption is suspect in the production of Table 5, it must also be suspect in regard to the production of Table 6.

The third observation is that it is assumed that in regard to Tax-Exempt Investors, namely RRSPs, RRIFs and Pension Funds that no tax is paid. While this is true, it was noted in my discussion of Section 3 above that in respect to these Tax-exempt entities tax is only deferred, not eliminated, and that the contributions to RRSPs and RRIF that are later withdrawn and that the contributions to Pension Plans that are later paid out, are taxed as ordinary income in the hands of the investor or pensioner. Therefore the loss in Federal tax revenues is less than purported by Table 5.

Comment on Section 6 - Economic Efficiency Issues Related to FTEs

a) Economic Efficiency

The notion that the corporate structure is suited to growing businesses or the FTE structure may be more suited for mature businesses almost seems a stereotype. Today many Energy Trusts have lowered their payout ratios of cash flow, a few even as low as 50 percent. This means that the replenishing and growing of oil or gas reserves is being done through internal organic growth or financing. Many Business Trusts have grown ably by means of secondary offering of units which increases liquidity or by issuing debentures. But the overall point is, growth is being achieved by many income trusts. BFI Canada Income Fund (BFC.UN) which specializes in non-hazardous waste management is a good example of a growth income trust because the purchase of the U.S. IESI Corporation or asset has made it a major player in North America.

Some American companies have realized there is benefit to the low tax FTE model. Custom Direct Income Fund (CDI.UN) owns an American company which is a major direct-to-customer cheque provider, but since most unit holders are in Canada, income travels north to the benefit of our Canadian CCRA. ACS Media Income Fund (AYP.UN) which owns a yellow pages company in Alaska is another example of income being imported into Canada.

It is true that some large corporations are spinning out mature portions of their business into Income Trusts in order to raise capital to invest elsewhere in growth areas. For example, the Noranda Income Fund (NIF.UN) spun out by Noranda produces refined zinc in the metals sector.

The implications are that the FTE structure is suited for both mature or growth companies and allows for the efficient movement and use of capital which puts to rest the notion that capital is only being invested in sluggish businesses to Canada¹s detriment.

From another point of view the requirement to distribute income to unit holders instills a discipline in management. Management must make decisions that meet distribution requirements at the same time they must retain enough capital for maintenance purposes or raise capital in the equity or debt markets in a disciplined efficient way so that both distribution and growth goals are met.

Recent studies have also shown that Corporations who pay out dividends and who in particular grow the dividend pay outs year after year achieve more growth than companies who retain all of their earnings for growth. Indeed there are many examples of companies who retained their earnings yet achieved little in their attempts to achieve growth. BCE or Bell Canada Enterprises is a good example of this. In the 1980¹s BCE bought the real estate company Brookfield Development Corporation. In the 1990¹s BCE bought the financial services company Montreal Trustco. In 2000, BCE bought into the idea of convergence with several purchases including Teleglobe. Taken together, these attempts at growth ended in losses in the billions of dollars. The point is their is no innate wisdom in Boards or the executive offices of corporations or income trusts that ensure retained earnings will be used wisely and efficiently. Yet investors who receive dividend or trust distributions on the other hand tend to look for managements with a record of efficient use of capital, and reward those companies or income trusts with a higher market value.

To conclude, despite stereotypes, both FTE and Corporate structures can provide for the maintenance of a mature business or the growth of a business, but both structures are dependent on good management.

b) The Role of Tax-Exempt Investors

Although as the Finance paper points out, pension funds as a group are the largest class of investors with a market value equal to around half of the TSX market capitalization, an examination of pension fund portfolios show that much of their investment is in the U.S.A., Europe and Asia making their weighting in the TSX market of less significance. The likelihood of undue influence in the Canadian market is less problematic therefore.

Indeed, perhaps the opposite is true. For example, the Ontario Teachers Pension Fund has been outspoken in its demand for good corporate governance practices, and for the protection of minority shareholder rights. In this respect pension fund influence has been for the good.

The 2004 budget proposals to restrict pension funds from investing more than 1 percent of their assets in business income trusts, and from holding more than 5 percent of any one business trust seem to be inappropriate from at least two different points of view. First, it imposes an arbitrary limitation on one type of investor leaving it at a competitive disadvantage relative to other institutional investors in the market place, distorting the level playing field desired for investment. Second, it is well known that defined benefit pension funds in a low interest rate environment have significant unfunded liabilities that will be difficult to meet in future years. It seems logical therefore that pension funds be allowed to compete for and invest in any type of market investment that will maximize their returns on investment and, therefore, help them meet their future obligations to their pensioners.

Comment on Section 7- Potential Policy Approaches

The finance paper suggests three different policy approaches: limiting the deduction of interest expenses, taxing FTEs like corporations, and better integrating the personal and corporate tax system, a phrase which implies reducing double taxation.

Before commenting on these options it is beneficial to look at Table 2 in Section 2 which compares how $100 dollars of income is taxed at the corporate and personal levels when this income is distributed by an unincorporated business, a public corporation and a small business or Canadian Controlled Private Corporation (CCPC). But I will revise the table by adding a fourth business, the FTE structure or Income Trust in order to enhance the comparison between structures. The Income Trust tax rate applied in the revised table is found in Figure 4, Section 3 regarding the tax treatment of FTEs in respect to Taxable Canadians.

Revised Table 2. Integration of Personal and Corporate
Income Taxes Under Various Business Structures

Unincorporated Public Business CCPC Corporation  (Small business) Income Trust

1. Business or entity income $100 $100 $100 $100
2. Effective corporate income tax rates
   Federal 0 22.0% 13.1% 0
   Provincial 0 13.0% 5.7% 0

Total 0 35.0% 18.8% 0
3. Amount distributed to individual $100 $65.00 $81.20 $100
4. Effective personal income tax rates
   Federal 25% 14.6% 14.6% 25%
   Provincial 13% 7.9% 7.9% 13%

Total 38% 22.5% 22.5% 38%
5. Personal income tax $38.00 $14.63 $18.27 $38.00
6. After-tax amount available to the individual $62.00 $50.37 $62.93 $62.00
7. Combined corporate-personal income tax rate 38.00% 49.63% 37.07% 38%

It is clear from this chart that for Income Trusts, the combined corporate and personal tax rates is the same as for unincorporated and small business CCPCs. Moreover the only entity not receiving equitable tax treatment are public corporations whose tax rates are about 12 percent higher than the other three entities.

In respect to the proposals to limit the deduction of interest rates by operating entities, only the business corporation should have its interest deductibility adjusted if this can bring its total combined tax rate in line with the other three entities which already have equality of taxation at the 38% level.

In respect to the proposal to tax FTEs in a manner similar to public corporations, if this proposal were applied, Income Trusts would pay 49% combined corporate and personal tax creating an uneven playing field because then both Income Trusts and public corporations would be paying more combined tax than unincorporated businesses or CCPCs.

One can only conclude that the correct option is to better integrate the personal and corporate tax system by removing double taxation of corporate dividends and by reducing corporate taxation so that the total personal and corporate tax on Public Corporations is 38 percent like that of the other business entities, thus providing the level playing field businesses desire.

Misguided attempts to change the tax treatments of Income Trusts would only succeed in damaging the market values of these investments and in reducing the trust income stream to the investor while distorting the level playing field once again.


The following points have been made in this response to the Department of Finance paper:

a) FTEs do pay less combined personal and corporate taxes than Public Corporations but less than the Finance Department paper purports because contributions to RRSPS and Pension Funds only provide tax deferral, not tax elimination.

b) The projections of tax revenue loss are too large because tax deferred income is not taken into account.

c) Both Corporations and FTEs appear adept at maintaining their businesses or growing their businesses with the key factor being good management.

d) Spinning out a mature portion of a business into an FTE to raise capital for growth in another area makes sense.

e) The discipline of having to pay out distributions or dividends, while at the same time managing growth, forces the management of an FTE or Corporation to plan and act wisely and efficiently.

f) Pension Funds need to be able to compete on a level playing field in order maximize returns to offset their unfunded liabilities.

g) Since Income Trusts are taxed the same as unincorporated businesses and small business CCPCs, there is no real tax leakage, only too high taxes for Public Corporations. It is changes in the tax treatment of Public Corporations that need to be made, not changes in the tax treatment of Income Trusts to ensure there is equality of tax treatment and a level playing field for all businesses.

In conclusion, it is my opinion that the Department of Finance¹s fear of tax leakage is a red herring brought about by ignoring the receipt of deferred tax revenues. Moreover it is completely unreasonable that the Department should be seeking ways to squeeze more taxes from Income trusts or Income Trust investors to address this exaggerated leakage when it is Public Corporate tax rates that are out of balance.

The line of thinking the Finance Department should be taking is, how can we cut taxes further so that saving and investment can flourish? It seems the lesson of Ireland's experience is not appreciated by some officials in Ottawa, namely that a lower tax rate means more growth in business, and more employment and consequently rising tax revenues.

Submitted as an individual investor and retiree,

R. Douglas Edmondson
Ottawa, Ontario

You have my permission to post my response to the Department of Finance paper on your web-site.

My preferred method of communication is e-mail, and my language of choice is English.