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Warren and Eva Jackson'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:
A number of general comments as well as comments about the conclusions of the Consultation paper follow:
A) The government encouraged income trusts initially. As a result, Canada has devised an innovative and vibrant addition to the capital markets in the form of income trusts. Income trusts are perhaps the best way of channeling the results of productive Canadian enterprise that directly results in prosperity for a broad group of Canadians. Indeed, the discussion paper itself states "FTEs shift the point of taxation from the operating entity to the investors, effectively achieving "full integration" (i.e. no element of double taxation) of the corporate and personal income tax system." Their burgeoning success is evidence that they are meeting an obvious need.
B) Other than tax implications, which may be overwhelmed by other factors, the primary difference between corporate structures and income trust structures is that the latter assumes that investors deserve a decent return on their investment and that with a return, they too can reinvest. Corporate structures assume -- as many bankers assume -- that investors don't know very much and that the retained earnings they don't get are fair game for investment opportunities that may not be in their best interests. Indeed, the report even states "In addition, 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." Obviously, no one has perfect information, including corporate (rather than FTE) managers.
C) Income trust structures also emphasize far more transparency and openness in governance and management, It is my experience, in talking to other investors and in participating in discussion forums, that trust unit holders are much more involved and aware of the on-going operations and the investment decisions made by the company underlying the trust. The obvious tight coupling between the company's success and distributions paid by the trust make this essential for any thoughtful investor.
D) The abstract concept of economic efficiency needs examination. There is no credible evidence that income trusts and FTEs in general are not "economically efficient". In fact, the usual wisdom is that money in the hands of individuals, who make their own purchase and investment decisions, is actually the most economically efficient model. FTEs encourage this model exactly.
The premise that fast-growing companies that convert to an income-trust structure are restricted in their ability to fund growth because they pay out a high distribution is not accurate. Income trusts with significant growth prospects and investment opportunities have proven to be the biggest winners in the trust sector. Examples are Energy Savings Income Fund, BFI Canada Income Fund, and Canadian Oil Sands Income Fund.
The notion that high levels of distribution staunch growth fails to consider that there are alternative funding sources to internally-generated cash flow. Income Trust companies merely go the market with secondary trust unit offers. These are so well accepted that it is almost impossible for retail investors to buy on the initial commission free offer. It looks as though new equity funding may actually be preferred by investors to internal funding. Trusts also have the ability to use lower payout ratios in order to partially fund growth opportunities. There is also a connection between the purported tax-advantage of the trust structure, and the positive relationship such an advantage has to the future profit growth of a company.
E) A question to be addressed is whether reduced taxes on dividends really encourage an increase in the "investment options" for investors? The answer depends on speculation about what managers in standard corporations would do under such a regime. It may well mean that corporations would need to pay out less to deliver the same returns to investors. Corporate managers might look to less efficient or riskier investment opportunities to use up the new excess cash so realized, including possibly paying themselves more in order to find those investment opportunities.
F) The discussion paper, in its analysis, concludes that 300 million of tax "leakage" occurred in 2004. If true, this amount represents only about 15/100ths of one percent of the total revenues of the federal government, which is currently running at least a 6 billion dollar surplus. However, the justification for this "leakage" conclusion is not at all obvious, as will be explained in more detail in the following points. First, the HLB study: (HLB Decision Economics Inc., "Risk Analysis of Tax Revenue Implications of Income Trusts," March 11, 2004), referenced in the Consultation Paper, in fact concludes that, for a previous year, the most probable result is that the "leakage" or shortfall for that year was either small or zero.
G) It must be kept in mind that any draconian measures to recover this purported 300 million amount will undoubtedly result in the loss of billions of dollars of personal net worth for millions of Canadians as well as the loss of value of pension funds that so many more depend on, and will obviously have negative effects for the country as a whole. Somehow that result does not seem like a good trade-off.
H) There are a number of assumptions made in the discussion paper, seemingly to simplify the analysis. Many are either wrong or unjustifiable. First, when the discussion paper refers to "tax-exempt" investors, it fails to acknowledge that these are in fact tax-deferred investments such as RRSPs and pension funds. For these, the taxes on distributions will be paid eventually, and treated as straight business or interest income, at the highest personal rates, with no account being given for the dividend tax credits (DTC) or capital gains that would otherwise have been considered in terms of advantageous tax treatment. These taxes should be included, at least at net present value, as is done in the HLB study referenced above.
I) The paper assumes that in the absence of FTEs, the same investors would hold common shares in the same entity structured as a corporation. The same assumption is made for the relative proportion of shares that would be held in tax-exempt accounts. While these are easy assumptions to make and make the analysis easier, neither can be justified. These assumptions point out what may be the basic flaw in the analysis comparing the two types of entities (corporations and FTEs), that they are assumed to be just variations on a theme when they are significantly different at a very fundamental level.
J) There is an assumption that standard corporations will distribute all their after tax earnings as dividends. This is obviously not the case for nearly any such entity. That, at least, is why dividends from most corporations can not be counted on for reasonable returns on capital for the Canadian retail or RRSP investor.
K) It is also assumed that all income trusts distribute 100 percent of their earnings. This is definitely not the case. Indeed, a cursory examination of the income trust universe through the iTrustInvestor Index and Report indicates that over half the trusts pay out less than 91 percent, with an average payout of 86 percent. But little has been done to establish standard definitions for payouts. According to the consultation paper, income not distributed is taxed at the normal corporate rate. And furthermore according to the findings in the iTrustReport, some companies retain cash for planned capital expenditures, to maintain working capital or infrastructure. Less than 100% of the earnings might be distributed because, like productive asset-based companies, income trusts in various sectors use their net cash flows for growth, for buying new assets or for exploration activities to discover new resources.
Warren and Eva Jackson