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Enterprise Capital Management Inc. Submission in Response to Finance Canada's Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships) consultation:

October 31, 2005

The Honourable Ralph Goodale
Minister of Finance
House of Commons
Ottawa, ON
K1A 0A6

Dear Minister Goodale:

RE: Flow Through Entities

We are writing in response to the Consultation Paper (the "Paper"), published by the Department of Finance ("Finance" or the "Department") on September 8, 2005, seeking submissions on the issue of Flow Through Entities ("FTEs").

In principle the process of consultation is a desirable approach, however, we are very concerned that your Department has pre-judged this process and has a strong bias against FTEs. The abrupt suspension of advance tax rulings more than a decade after the first FTEs were established but just 11 days after a call for consultation certainly suggests this is the case. A detailed review of Finance's Paper appears to confirm this bias.

Of far greater concern, our review of the Paper has revealed significant flaws in the Department's analysis that, unless corrected, could lead to conclusions and policies that run directly counter to the goals of preserving Canada's tax base and enhancing its economic productivity.

Over the past 24 months the Toronto Stock Exchange has been among the best performing equity markets in the OECD. FTEs generally have outperformed the TSE 300 Index. A healthy equity market encourages investment and improves consumer confidence. Confidence is difficult to build and easy to destroy.

As others have noted, in an apparent effort to protect $300 million in potential tax revenue, the process followed by your department has so far reduced the market value of FTEs by an estimated $21 billion, with a corresponding loss of federal tax revenue (using Finance's assumptions on ownership) in excess of $1 billion. Aside from the damage this has done to Federal tax revenues, it has caused considerable uncertainty in the market, and anxiety among investors, particularly seniors who rely on income from FTEs. The Government needs to be very careful not to permanently damage the success of FTEs because the consequences of destroying the savings of Canadians will be to damage investor and consumer confidence.

Our goal in making this submission is to provide facts and analysis that will assist your Department in its deliberations.

The Paper discusses the impact on Federal tax revenue and economic efficiency as a result of the growth of the FTE market. We will comment on each separately.

Loss of Tax Revenue

We believe the calculations in the Paper with respect to lost Federal tax revenue are materially flawed as a result of biased or erroneous assumptions and inadequate knowledge as to the dynamics of the Canadian capital market.

The Paper estimates that the tax revenue to the Federal government would have been $1.5 billion in 2004 from the entities that had converted to FTEs had such entities remained traditional corporations. We believe the assumptions underlying this conclusion, and the conclusion itself, are deeply flawed. Our analysis follows.

Assumption I

The ownership of corporations by type of investor is the same as it is for FTEs or as stated "it is assumed that Canadian taxable investors are holding FTEs in place of dividend-paying equities":

Analysis:

This assumption covering this "key parameter" demonstrates either a bias or a lack of understanding of Canadian capital markets by the Department of Finance.

FTEs are high yielding equity investments. FTEs have stimulated — to an extent never before seen in Canadian economic history — investment by taxable Canadians in equity investments in place of their traditional preference for bonds, preferred shares, GIC's and bank deposits. The alternative to FTEs for taxable Canadians is not investment in dividend paying equities but to return to traditional investment patterns, with adverse consequences for tax revenue, returns on savings and economic efficiency.

The ownership of FTEs includes a much higher proportion of taxable individual investors than would have been the case had such entities been public corporations. Data in published studies referenced by the Paper, such as the Mintz and Aggarwal ("Mintz") article, "Income Trusts and Shareholder Taxation: Getting It Right," suggests tax exempt ownership of public corporations is quite different from that assumed by Finance.


Ownership of Canadian Equities


Department of Finance Assumption Mintz Aggarwal Assumption

Taxable Canadian 39.5% 23.2%
Tax Exempts 39.1% 47.4%
Non Resident 21.4% 29.4%

The Mintz assumption as to ownership of Canadian equities by taxable Canadians was only 60% of the ownership level assumed in the Paper. The Mintz analysis did not assume equal ownership of FTEs and corporations. Changing ownership assumptions would have a significant impact on tax revenue estimates.

Assumption II

Distributions received by Pension Plans and RRSP's are never taxed.

Analysis:

Pension Plans pay pension benefits to recipients who are taxed on that income. Payments from RRSP's or RRIF's to holders are also taxed. In fact, all else equal, tax revenue ultimately received from taxes on distributions from RRSP's and pension plans exceeds tax revenue that would have been collected from investors directly because regardless of whether it was originally interest income, dividend income or capital gains it is now all taxed as ordinary income. For the year ended December 31, 2004 the Ontario Teachers Pension Plan reported that it had paid pension benefits of $3.4 billion, all of which is taxable and exceeds reported investment income from interest, dividends and inflation-sensitive investment income. Benefit amounts are expected to grow rapidly, driven by fundamental demographic trends. For the same period the Ontario Teachers Pension Plan reported net gain on investments of $7.5 billion. If these gains were received directly by plan members and taxed as capital gains federal tax revenue would have been $938 million. Federal tax revenue on the same investment return but received as pension benefits would be $1.9 billion.

By definition, relative to the corporate model, most tax revenue from FTEs is received from investors. Ignoring an important source of tax revenue from FTE investors is surely offensive to those who pay the tax, prevents a proper analysis and suggests a bias against FTEs. If nothing else, the assumption that investment income received by tax exempt entities is never taxed is entirely inconsistent with the Paper's assumption (discussed below under Assumption VI) that earnings retained by corporations for reinvestment should be assumed to be taxed as a capital gain currently even though the ultimate profitability and tax revenue from such reinvestment is uncertain and deferred.

Assumption III

The amount of federal tax revenue in 2004 from capital gains from conversions and IPOs was $40 million.

Analysis:

Based on discussions with private equity sponsors and a review of the difference between purchase price and selling price evident from IPO disclosure documents, this estimate understates federal tax revenue from conversions and IPO's.

With respect to conversion revenue estimates, Finance utilized a 13% increase in value based on a study by Professor Halpern of the Rotman School of Business, University of Toronto. Professor Halpern measured gains based on the relative performance of converting corporations but did not review relative performance for a period longer than 21 days prior to disclosure of an intent to convert. This methodology does not consider the sophistication of the market in selecting appropriate candidates for conversion and "pricing in" the value of conversion commencing well before the 21 day period.

With respect to IPOs we believe that most FTE IPOs take place at a 25% to 50% increase in value relative to non-FTE disposition alternatives (e.g. a sale to a private equity sponsor). For example in September of 2002 two financial sponsors acquired 90% of the Yellow Pages business from BCE Inc. for $900 million. In August of 2003 the Yellow Pages Income Fund undertook an IPO which valued the original investment of the financial sponsors at $2.1 billion. It is probable that the one-time tax revenue from capital gains in 2004 as a result of conversions to the FTE structure was in fact many times greater than the $40 million estimate used by your officials based on a more realistic estimate of the capital gains as a result of the FTE structure.

Assumption IV

The Federal tax revenue from corporate taxation should be based on average corporate taxes paid as a percent of EBITDA for the 2000 - 2003 period.

Analysis:

The preponderance of entities, apart from those in the oil and gas sector, that have been created as FTEs or converted to FTEs are businesses that would have carried above average degrees of financial leverage because of the mature nature of these businesses. This is particularly true of the real estate, pipeline and power trusts where, in the traditional public corporate model, financial leverage is at its highest. Further, many of the business trusts are entities that would have been purchased by leveraged buy out funds had they not been sold to the public via the FTE structure, so that the financial leverage implicit in that type of transaction also would have reduced current corporate tax payment to a minimum.

Other entities would not have been suitable public corporations and would have remained in private hands where opportunities abound for "informal" tax integration. Still others would have been owned by the merchant banking arms of pension plans employing tax efficient structures to minimize tax paid at the corporate level. Applying average corporate tax rates as a percent of EBITDA provides a federal tax revenue estimate of some $875 million. This substantially overstates the likely reality. The actual tax revenue would certainly have been much lower because of the nature of the assets relevant to the FTE market, and their likely capitalization as corporations.

Assumption V

The level of EBITDA would have been the same whether the entities were structured as corporations or as FTEs:

Analysis:

FTEs generate a higher level of economic activity to be taxed than would have existed under a corporate structure because (a) the cost of capital is lower so projects are viable for FTEs that would not have been viable in a corporate structure; and (b) Canadian domiciled entities own assets or businesses in foreign jurisdictions, including the United States, Australia, France, Chile, the Netherlands and elsewhere because of their efficient cost of capital. In a traditional corporate structure it is unlikely that they would have been able to acquire many of these assets or businesses. With the FTE structure a substantial flow of funds must come from those jurisdictions to Canada to be taxed in Canadian hands as distributions. As a result, the level of EBITDA and taxable income to investors is higher with the FTE structure than with the corporate model, or than is estimated in the Paper.

As noted below, many businesses now operating as FTEs would not be public entities except for the existence of the FTE market. They would, in the alternative, be owned by private equity sponsors and capitalized with maximum amounts of debt, retained under private ownership or sold to corporate purchasers, likely non-Canadian.

Assumption VI

Earnings retained by corporations should be assumed to be taxed at the capital gains rate as a proxy for the value increment being accrued by shareholder investors.

Questionable/Inconsistent:

$240 million (80%) of the net revenue loss estimated by Finance arises from the assumption made that earnings retained by corporations would produce sufficient capital gains ($1.9 billion) in the hands of individual taxpayers that the government would collect on a current basis approximately $240 million of capital gains tax. When Pension and RRSP owners of FTEs receive $3.5 billion of distributions, however, your officials assume that this income is never taxed.

As discussed above there is a logic to the concept that earnings retained by corporations will eventually result in capital gains being realized by shareholders, but that is logically inconsistent with assuming that amounts paid into pension plans and RRSP's are never taxed.

Revenue Impact of Normalizing Assumptions I and II

If one accepts all of the other assumptions made by Finance in the Paper and only:

(a) adjusts the assumed ownership profile of corporations to that used in the Mintz/Aggrawal article; and

(b) attributes current tax revenue to distributions received by tax exempt investors from FTEs consistent with attributing current tax revenue to the undistributed income of corporations;

one finds that the impact of FTEs is positive to Federal tax revenue.

The magnitude of the estimated positive impact FTEs have on Federal tax revenue increases significantly when reasonable assumptions are made about: the true impact of capital gains from conversions and IPOs; the validity of using corporate taxes paid as a percentage of EBITDA as a basis for calculating Federal tax revenue from corporate taxation; and the estimated level of EDITDA resulting from entities structured as FTEs rather than as corporations.

Comments on Economic Efficiency

Canada has historically been a net importer of capital as is the norm for a developing, resource rich nation. This has historically provided us with relatively high interest rates, high personal and corporate tax rates, a small and risk adverse portfolio of financial institutions and, as a result, a high cost of capital.

As a result of the creation of the FTE vehicle, a number of major sectors of the Canadian economy enjoys, for the first time, a cost of equity capital that is competitive with any in the world. It is axiomatic that a low cost of capital provides a source of competitive advantage; a high cost of capital decreases competitiveness and productivity.

Canadian FTEs can compete with private equity funds (Canadian Pension and US based) to acquire Canadian businesses, keep them in Canadian hands and see at least a portion of the wealth they generate taxed in Canadian hands. In fact, based on evidence cited in the Paper, FTES are owned by individual Canadian taxpayers to a much greater extent than Canadian corporations generally. Further, the same entities can expand internationally and acquire US and international businesses in competition with the same private equity capital pools and in competition with much larger, more creditworthy, entities.

The only meaningful issue with FTEs from an economic efficiency perspective may be the constraint on such entities investing in businesses and projects that are longer term in nature.

To this criticism we would reply:

(i) the FTE market has evolved so analysts and investors are looking for less than 100% payouts of distributable cash so a margin of reinvestable capital is being created for longer term investing;

(ii) the FTE structure effectively requires managers to seek new capital for new projects. The discipline this places on management, and the ability it gives to the market to most efficiently allocate capital, is a significant benefit to the Canadian economy. The Canadian record of large corporations diversifying outside their core business with shareholders money is not a successful one. Vast amounts of shareholder capital has been destroyed and tax revenue reduced as a result of this strategy induced, in part, by the corporate model; and

(iii) projects not suitable for the FTE structure but which otherwise have economic merit will be undertaken by others where a comparative advantage exists for investment in such projects.

Failure is swiftly punished in the FTE structure. Unit prices respond dramatically to reductions in distributions. Additional capital is punitive to stakeholders. This discipline establishes a favourable environment for economic efficiency.

When considering the total impact of FTEs on economic efficiency, a strong source of income (and for many, retirement security) for Canadian investors and federal tax revenue, I urge your Department to consider the example of Superior Plus (TSX: SPF.UN). The following is an excerpt from a press release issued by Superior Plus on October 20, 2005; the comments are attributed to Mr. Grant Billing, Executive Chairman:

"Superior Plus was one of the first Income Trusts to become public in October 1996 and is very proud of its record in stimulating significant economic activity and value. It has managed its businesses to promote strong gains in economic efficiency. The FTE structure demands this approach through the efficient allocation of capital and transparency of financial reporting. Superior Plus has expanded internationally, acquired Canadian and non-Canadian businesses from non-Canadians and in the process added to the income flows to be taxed in Canadian hands. We have also started new businesses from scratch. Over nine years we have invested $2.3 billion in building our business for the benefit of all our stakeholders. Distributable cash flow per trust unit has increased from a forecast of $1.15 per trust unit at the time we went public in 1996 to $2.51 per trust unit generated in 2004, evidencing our ability to improve our productivity and profitability. In the process we have distributed in excess of $800 million in taxable interest and dividends to approximately 44,000 investors, most of whom are individual Canadian investors with relatively few tax-exempt pension plans. In addition, our investors decide how to re-invest these distributions, which results in further efficiencies to the economy, as investors generally redeploy their investments in the most profitable investment opportunity. Superior Plus has raised $1.6 billion in capital which now has a market value of $2.3 billion, representing potential capital gain tax revenue for governments. This would not have been possible without the FTE structure. Canadian individual savers and governments have been winners as we continue to make substantial contributions to the Canadian economy."

Summary

In summary:

1. FTEs expand the amount of income available to be taxed.

2. The ownership of FTEs by taxpayers exceeds their ownership of corporations, expanding the flow of funds that is currently taxed.

3. The alternative to FTE ownership for Canadian taxpayers should not be viewed as equity ownership in public corporations but rather a return to investment in deposits, bonds, GIC's and preferred shares which would reduce the flow of funds to be currently taxed and increase the cost of capital to many Canadian businesses.

4. The alternative to the FTE structure for the ownership of assets and businesses suitable for FTEs is not public ownership of corporations by taxpayers but ownership by private equity funds using capitalization strategies to reduce tax payments, retention by owner-managers undertaking "informal" tax integration or sale to foreign purchasers.

5. Distributions by FTEs to pension plans and RRSPs generate tax revenue as benefits are paid to pensioners and RRSPs mature.

6. IPOs and conversions generate substantial amounts of tax revenue from capital gains.

7. FTEs encourage economic efficiency and growth in many sectors.

In our view any reasonable rebalancing of the assumptions made by Finance in the Paper would result in demonstrating that FTEs generate significantly more tax revenue than the traditional corporate model.

Permission to Post Submission On Website

Permission is granted to post this submission on the Department of Finance Website. Relevant contact information is contained in this letter.

Conclusion

Capital markets hate uncertainty. The Paper did not create uncertainty but your subsequent comments have. Given the December deadline for submissions under the consultation process, the timing of the Gomery Report, the Budget and election timing, this uncertainty is likely to be with us for an unacceptably long period of time, damaging investor and consumer confidence. That is an unacceptable handicap for the most efficient element of the Canadian capital market and that should concern you greatly.

FTEs have contributed to Canada's economic success without any demonstrated negative impact on tax revenues. We encourage you to preserve this success and the savings of Canadians.

Yours truly,

Enterprise Capital Management Inc.

J.S.A. MacDonald Chairman & Managing Partner 416-955-4602 jmacdonald@enterprise-capital.com
D.P. Smith Managing Partner 416-955-4603 dsmith@enterprise-capital.com
E.L. Schwitzer Managing Partner 604-661-3313 eschwitzer@enterprise-capital.com
M.J. Brown Partner 416-955-4604 mbrown@enterprise-capital.com

 

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