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Michael James (Jim) Grant'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:
September 27th 2005
Attached is a response to the consultation paper that the Department of Finance has distributed on Tax and Other Issues Related to Flow through Entities. It is an open response directed to the consultation process as well as other stakeholders, at least one member the financial media, my MP, and the Canadian Tax Foundation because of their mention in the consultation paper. I am sure I will circulate it beyond that as well. What were to be my opening remarks in this response are nearly 1000 words now, so I am writing this covering letter to make a succinct summary of what I want this response to accomplish:
- Express my concerns over the voices to be heard in the consultation process and the ability of stakeholders to actually influence the eventual determinations of the government;
- Call for a more open and involving process
- Make suggestions about resolving some of the perceived issues
- Explain some issues I have with omissions, misleading presentation, and some bias I see in the consultation paper
- Signal a strong desire to be involved in this consultation process
I am not going to be apologetic for expressing the concern that my voice and those of many whom I see as important stakeholders will be ignored or merely paternalistically placated by the entire process of public consultation and eventual legislative and/or administrative action taken by Parliament and/or the Department of Finance. I see the consultation and further action to be the continuation of a much longer standing initiative to make certain changes, and feel that the goals and motivations of this initiative biases the current process.
Michael James (Jim) Grant
Tax Policy Branch, Business Income Tax Division
Department of Finance,
17th floor, East Tower,
140 O'Connor St.
Response to the Department of Finance Consultation on Issues Related to Publicly listed Flow-Through Entities and the consultation paper: Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships)
CC: Mathew Ingram of the Globe and Mail
The readership of several threads on Stockhouse
My MP, Lee Richardson
Steven Richardson, Director and CEO, The Canadian Tax Foundation
I am concerned, not just for myself, but for hundreds of people I communicate with regularly. I have read and heard shock, horror, fear, anger as well as wishful thinking and denial in the week since the announcement was made that advance rulings on trusts would be suspended pending the result of the public review of income trusts. I have seen the results of several ad hoc polls of roughly 150 to 200 trust investors conducted at six month intervals showing that the majority of those who discuss them in one of the several online investing forums that I participate in are semi retired or retired (65% last poll in July) and a larger majority (70% in the July poll) are over the age of 55. Of the respondents in the last poll the average asset allocation into trust was 70% and this was relatively similar between all age groups. I consider my own allocation to trusts to be extreme however as a group these people have nearly double my allocation. The fact that there is a vocal, collaborative, and to a large extent methodical group of investors at or near retirement who feels this is the best alternatives for their investment dollars suggests that despite risks the benefits of the vehicle are important. These individuals should not be dismissed as misguided outliers, but instead should be viewed as the stakeholders with the most to gain or lose by decisions about the future of trusts. Pension funds and other institutional investors may make comments and presentations on behalf of their clients, but they are generally salaried employees of those clients and may be more aligned to the benefits to their organization and salaries than the beneficial interests of their clients. The direct stakeholder investors, particularly those who have no recourse besides government plans and programs for retirement income beyond their own investments, should carry significant weight. They rely on the income that can be generated with trusts and its tax advantage, not because the underlying business is mature, but because they are! They look to an asset that matches their needs. There are few investment vehicles of comparable income as alternatives and these investors have sought out what has been demonstrated to them as the safest, most easily assessed and monitored, investment vehicles. Trusts are not the same as junk bonds, and while as individual business entities Trusts can have a range of low to high risk inherent in their own business, their business sector, and general market risk, each can be analyzed and weighted by investors as part of a methodical due diligence process. Junk bonds by definition are bonds where the underlying guarantee is deemed to be at risk, most other high income investments fit the same category. Trusts simply put the unit holder at the end of a more volatile stream of income, however the underlying businesses vary in risk from the quite secure, long term stable and financially sound to the highly leveraged resource plays in the midst of a resource bull cycle. This diversity allows the individual investor to diversify within this group while still benefiting from advantageous income and income that in many instances has important tax advantages to the investor.
I am concerned about the potential for a change in the fundamentals of 40% of my wife's and my portfolios, our allocation to this security type. But it is fundamental changes due not to a change in the economy, the fortunes of individual businesses, or the dynamics of volatile sectors like Oil and Gas or food and beverage, but instead by an action of the government of Canada that can change the basis on which the markets value these investments and the ability of these businesses to continue to provide us with income.
I am also concerned about another effect that the actions, or rather inaction, that the government has announced about the income trusts is having. This is the confusion of otherwise methodical investors, particularly those who are making decisions without any knowledge of the fundamentals of their investments(not their ignorance in the nature of the businesses that their trusts operate but the change to the fundamentals of taxation, capitalization costs, and other possible changes to the rules under which they are formed and operated): some selling in fear, some buying in denial, some holding while worry starts to impact their health. I like to think of myself as an investor awareness advocate. I discuss investments with people online. I have a daily podcast/report on the energy futures market to help inform my listeners and readers about the issues affecting Oil and Gas investments in North America. I don't try to tell people what they should invest in. I do try to help inform them with as little bias as possible, and when I am aware of imparting a bias in my communications, to explain any bias I am conscious of putting in my postings. When I do write a letter like this that tries to influence change, it has always been with the intention of getting better information out there available to investors.
I have now expressed my concerns, let me express some ways I see that the government and investors can move forward to make the best of the investment environment that exists in Canada.
First, this review process needs to be more public than it already is. If publicly traded corporations and income trusts can disseminate information to share/unit holders via brokerage houses, so could the government. Let us see surveys and other involving communications sent to all investors in trusts via the brokerage houses with succinct language and simple solutions offered.
Second, each individual Income Trust exists today because the rules under which they were formed encouraged their existence by generating the perception in the majority of their investors that they were more efficient engines to generate income and preserve capital than their alternatives for the individual business in question. If there is fault in this perception, it is the business of the market, and the people who participate in the market to resolve this perception problem. Certainly if the Government did not feel a need to step in and explain the perception problems of a company with a negative tangible book value of billions of dollars being worth a significant portion of the entire TSX-300 index, I feel it is not serving the population by passing judgment directly or indirectly on the suitability of individual Income Trusts or the form of investment as an archetype. So my suggestion is that the Government, despite its commitment to a process to review Income Trusts, be very careful to stay away from making any changes based on perceptions of their efficiency as an investment vehicle and to also refrain on making public statements about their suitability or even allowing their review process to be co-opted by parties with a vested interest in having their views about the suitability of Income Trusts as investments as a platform to advance their personal agendas. I am concerned that Section 6A of the consultation paper and the question #3 unfairly biases all the participants in the consultation process to consider a relationship between the suitability of the investment vehicle that market forces should in fact determine once the rules under which all business entities operate under are once again made clear.
Third, I recognize that any tax legislation, and any change to existing tax legislation no matter how well thought out, can not be 100% equitable. As well, the more complex the framework of rules, exceptions, and process for administering the legislation is the more it discriminates against the least powerful but most deserving of investors. In this light I think that when changes in tax legislation are considered that they should counterbalance any new complications they add to the burden of understanding and administering on the part of the tax payer with simplifications in what legislation they replace or update. I would suggest that whatever changes to legislation are framed provide some simplification, or at least no more complication, on the part of the individual investor needs to perform initial and on going due diligence on their investments and on their administering their relationship with the taxation of their income generated by these investments. If complication needs to be added in any part of this system to make it equitable and fair, it should be added to the burden of those stakeholders who have an economy of scale in their activities. That is: pension funds and other institutional investors. The consultation paper pointed out the role that pension funds and other tax exempt stakeholders might have in creating an unfair business advantage for some entities over others (section 6B), the same could be said for adding the burden of complication equally on all FTEs (or even FTEs and corporations if the change was that broad) regardless of the size of the FTEs (and corporations).
Fourth, I see areas of the consultation paper that seem incomplete or misleading:
- Table 1 in section 2C of the consultation document presents the market cap of Income Trusts to have grown greatly in the period from year 2000 to 2004, yet it does not show that the value of the underlying assets from which trusts in 2004 are made up of increased by something on the order of 250 – 350% for Energy trusts, and 50 – 100% for REITS. Nor does it acknowledge that had all three types of trusts as well as Limited partnerships been treated as income investments (preferred shares for example) the change in prevailing interest rates would have increased their market capitalization by more than 100%. Add to this changes in the valuations, particularly of Energy Trusts and REITS because of this growth in value of existing assets which made it possible for them to go to the market and raise new equity to expand operations. Particularly Energy Trusts have benefited from a combination of 500 – 700% increase in valuation based on interest rate changes and increases in resource value. To characterize their growth from 2000 to 2004 as being new issues is not correct. Yes new capital has been raised by them, and many new energy trusts were created, but the asset growth and interest rate decline would appear to be more than a 50% contributor to the growth in this area. The government should not make a consideration of taxation rule changes because a commodity or interest rates have fluctuated. If there is a concern due to the rapid growth be sure to correctly identify the growth that is the result of new activity over and above the natural issue of replacement capital and value appreciation in the industry in question.
- When describing the differences in taxation between FTEs and similar operations organized as traditional corporations in section 3 of the consultation document there was a quantification of taxes paid under three types of organization as distributed among three tax categorizations which leads to a comparison of what was described as the total tax under each scenario, I see this as exaggerating the impact to tax revenue by ignoring the impact of the deferred taxation of the tax exempt investors. While it would certainly complicate the example more, I think it would be a much fairer comparison if a discounted impact of deferred tax were included. This would have to assess the effective delay of tax revenues and should be discounted at the current rate that government bonds effectively yield on the market for the appropriate terms assessed for the delays. This would have the effect of increasing the calculated tax impact of all three types of organization, but would more fairly represent the relative amounts of tax paid by all.
- In section 3A table 2 compares the integration of personal and corporate taxes under unlimited partnerships/sole proprietor with Public Corporations and CCPCs. As someone with experience owning all three and actively participating in the day to day operations of registered partnerships, a sole proprietorship and CCPCs, I see it as an unfair comparison to treat $100 of income from each of those as equivalent. If you look at the costs to the investor, they pay much more capital for each dollar of income from a public corporation than from unincorporated businesses or CCPCs. I find this a misleading comparison and while the existing table shows a higher cost of tax for the publically traded corporation it does not emphasize this as much as it should to account for the higher cost to purchase this income.
- In section 6A there is an implicit bias expressed in the paper as to the suitability of certain business to the trust format claiming economic inefficiency, and while, from the point of view of the tax authority it might appear to be inefficient at gathering tax, it is far from inefficient from the point of view of the business activities of some non mature business trusts and it is quite efficient for the investors. I would welcome an opportunity to present some positive examples of this, but only if I could do so to point out the fact that it is inappropriate for the government to develop rules based on a biased viewpoint rather than develop rules and let the market determine which formats work best for whom. Innovation is the main excuse for free markets and many of the incentives the Canadian Government has put in place for investment. This must include innovation to find the most efficient structures for business as well. To make a blanket statement that it is economically inefficient for growing businesses to organize as trusts is to stifle the very sort of economic innovation that any free market environment is meant to nurture.
- The Federal estimates for 2004 presented at the end of the consultation document shows no entry for corporate taxes of Income trusts, if it is insignificant it should be stated somewhere, but I do know that one of the Business Trusts I own units in did pay tax on funds as it distributed less than 100% of its pretax earnings in 2004. Its effective tax rate on EBITDA was 9.5% for 2004.
Fifth, partially in answer to question five of the consultation paper and in general as an expression of my desire for fair treatment by the government as an investor balanced against my actual expectations of the government:
I would rather see the government use little or no legislative changes to the rules under which trusts are organized and taxed, and if they must work to discourage corporations from converting to trusts I would suggest that they choose to eliminate taxes on dividends of corporations. I don't find this a particularly unreasonable approach given the level of surplus in current federal budgets. However that is not what I expect the government to do, I would expect them to make some changes to the taxation of the flow of cash from Trusts to investors, and I expect them to make some change that impacts that flow by about 5 to 10% of distributions. My concern is that if they make that adjustment and make any changes that impact the ability of existing trusts to raise new capital that the joint effect would be one that creates a precipitous drop in the valuation of trusts as a group by the market. I think that this would have a pronounced effect on a number of investors for whom trusts represent a vital component of income and capital. An alternative I see as less likely, but that would be preferable would be to leave the taxation of distribution from trusts intact, but instead to tax the portion of gain received on the sale of trust units which was the Adjustment to Cost Base by deferring return of capital taxation as potential impairment of the investment value as income rather than capital gains. This would have the most impact on those investors who treated Income trusts as speculative investment vehicles and allow those who depended on them for income to defer taxation until they made a fundamental decision to sell or until their estates were being wound up post mortem.
Sixth, I would like to have the opportunity to critique specific measures that this process evolves to deal with the apparent need to change the rules under which Income Trusts are formed. I think all stakeholders who have an interest should be able to do this before the measures are being considered in whole as a yea or nea, but where input on how the measures could be adapted to better fit the needs and goals of the stakeholders fairly while still providing whatever change the government feels is required. As I pointed out in my concerns, I think it is unfair to allow the stakeholders (pension funds, institutional investors) who have the economies of scale to afford to participate in this consultative process dominate this process as I feel they don't fairly represent the beneficial owners of their stake. As representatives they are attuned more naturally to their own success and failure in careers as representatives and wealth/portfolio managers. It is the directly investing stakeholder of moderate means (such as myself and a number of the people I am in touch with online, and many more who I don't know of due to their passive participation in online forums or their total separation from that online environment) that deserves a fair representation in this process.
I am a semi-retired private investor. In semi-retirement I have the luxury of choosing to work at certain jobs (ex. instructor in a Canada Employment Skills program) for relatively low pay because I feel it is a worth while contribution, while still feeling free to work at some higher paying activities. For my own benefit, and interest, I perform the work of managing a majority of my own portfolios (and consulting with my wife on our joint one) of which one part is performing ongoing due diligence on investments. This process includes assessing the impact of changes the government makes to the rules under which Income Trusts are formed and operated. Most important to me in the effort to manage my own portfolio is to share my ideas, information and information sources, and techniques with as many other investors as possible and learn from their perceptions, ideas and points of view. I will undertake to, as part of my unpaid or under paid activities, to do the best I can to represent my opinions, expectations and biases as a stakeholder, offer what I can of my knowledge of other similar stakeholders and their positions and views and disseminate to those who are interested both my observations of this consultative process and my interpretation and response to them.
Please communicate with me in English by e-mail, phone, fax, or postal mail as appropriate.
You may certainly feel free to publish this in all appropriate media as part of the consultative process including the Department of Finance website as indicated on Page 38 of the consultation document
Michael James (Jim) Grant