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Stewart Michael Lee'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:

For Submission to the Minister of Finance:

Dated: November 2, 2005

I am a late 50's semi retired professional. I have invested a significant portion of my liquid assets in unit trusts, being aware of the business risks, systematic and unsystematic risks in order to build a meaningful monthly recurring cash flow. I believe that previous jawboning and 'negotiating possible tax policy' in the press has precipitated a reaction of fear, panic and in some cases extensive loss in value for many equities. The market correction and lack of current liquidity suggest that the loss in market value is simply not due to normal market conditions; especially as quarterly results for many issues are positive with quarter over quarter and year over year gains on income statements and reflected in the balance sheets too. In a philosophical sense, 'Selling begets more selling' in the short-term and uncertainty is 'death' for equity markets. The future will demonstrate the practical financial implications as a result of careless or reckless policy suasion, and will demonstrate whether a potential loss in confidence in the capital markets becomes joined to the government's role in influencing future individual capital markets investment through tax policy. Negative changes in productivity as a result of FTE's is equally presumptive and without objective empirical evidence and logical inferences are deductive failures.

My opinion is developed in the following pages.


Policy challenges with respect to Income Trusts & Flow through Entities

This paper will address the policy challenge issues for consideration with respect to Income Trusts & 'Flow Through Entities' in particular.

The objective

is to review the Dept. of Finance policy paper and to raise additional points of investigation that extend beyond the net tax theoretically lost by peering into the future with a mystic's view; versus the net tax actually gained by the Federal government using empirical corporate tax receipt evidence for the past four years and current distributable cash paid to unit holders by 78 taxable issuers (Nesbitt Burns, October 3, 2005).

The Dept. of Finance modeling in the Sept. 8, 2005 paper has at least three major assumptions which in fact are wrong, self serving in financial analysis and produce conclusions that are not borne out by the empirical evidence (these factors will be detailed where applicable in the discussion below).

External Analysis:

The hypotheses tested by two review agencies relate to corporate structures and their taxable impact on the Canadian economy. Moreover, the extended cost/benefit analysis of the income trust structure considers investor average tax rates (25%) as the benchmark for win/loss revenue comparisons at the Federal level. (Dept.of Finance Canada, Sept.8, 2005).

Reviews of previous works by L. Aggrwal and J. Mintz (Sept.24, 2003) and HLB Decision Economics Inc.(March11, 2004) demonstrate that the assumptions used in generating financial, social and political conclusions by the authors, in fact form the basis for the differences in all conclusions for both external analyses.

The assumptions of both review agencies were:

1. Average company tax rate prior to income trust structure conversion, % of income funds held in tax deferred accounts, deferred tax implications and transitional capital tax gains. HLB noted that most 'converts' were already at lower tax rates and therefore the A/M analysis is flawed.

2. Next, a comparison of %'s of holdings in tax deferred RRSP accounts frames the analysis with a 22.3% net assumptive spread in tax/non account holdings that generates significant tax leakage conclusions. HLB takes the position that less leakage occurs.

3. Third, the A/M study does NOT include future revenues and their impact when withdrawn from deferred accounts while HLB's study does.

4. Fourth, the A/M study does NOT include any capital gains to the government upon conversion from a common operating company to an income trust.

HLB concludes that the impact of income trusts is 'likely to be neutral' to 'net positive'. Any data that had uncertainty was assigned probabilities. Combining the 2004 estimated current-year tax loss of $217 million. and the estimated future tax gain of $268 million., produced a net gain of + $51 million. to the government.

The probability study of loss vs. gain in revenue concluded that 10% of the time revenues received from income trust distributions could be greater than the foregone tax revenues on capital gains and dividends.

The probability of net tax loss to the government in excess of $409 million is expected to be less than 10% and a 10% probability that the government could see an increase in tax revenues as a result of income trusts – of about $72 million, according to this study.

Nesbitt Burns analysis of October 3, 2005 notes:

26% of tax is deferred (a return of capital tax treatment) for 60 income trusts and 18 royalty trusts. The 74% taxable represents 133 million dollars, @ an effective income tax rate of 38% yielding $50.62 million dollars in tax collected. (Gordon Tait, CFA, BMONB)

Future studies and consultation efforts are to consider the following issues and be part of a complete FTE review (and other tax exempt corporate structures)

:

1)

Impact that FTE public capital has when comparative efficiency analysis of capital deployment across the different corporate structures (in terms of producing higher roa, roc, roi, higher risk adjusted returns for shareholders in conjunction with productivity gains or not, for the issuers) is undertaken.

2)

Whether income trust superiority as a competitive taxation structure is a benefit to all shareholders (and to force corporations to produce winning business propositions to continue to provide distributable income to unit holders while still producing balanced economic impact) –

The Dept. of Finance analysis is flawed because it assumes taxes are paid on net income; however taxes are paid on cash distributions of the trust and not on the trust's net income – usually higher than the net income number. Nesbitt Burns' notes: cash distributions were approximately 1.8x the level of net income.

3)

The possible hidden political funding agendas that are masked as tax leakage issues

4

) The future benefits to issuers and investors through the efficient operating business structures required of income trusts, and with shallower pyramidal organization structures.

5

) No consideration has been given to the impact and sensitivity of all variable costs on ebitda and the resulting distributable income number, which will affect taxation receipts at all levels. Ebitda used as a financing parameter in the unit trust marketplace allows un/marginal/profitable enterprises under existing accounting rules to fund, capitalize and promote value in the capital markets. The result is a different opportunity to grow using flow through entities securities as currency – which can in turn to lead to greater internal productivity and rewards for unit holders and taxing bodies.

The problem of defining productivity in economic terms exists in any analysis because it is also definitional issue. The biases and filters that all analysts, proponents, beaurocrats and politicians use in debating the productivity problems relating to corporate structures are just that: biases and filters.

6

) A review should be conducted on the unit trust dividend reinvestment program as an efficient capital provider mechanism and as an efficient way to build investor cash flow on an ongoing basis without secondary financing costs or individual broker commission payments.

7)

The tax receipt gains or tax receipt losses, from taxpayers being shifted into different brackets due to the increased taxable income paid directly or indirectly to the taxable unit holder must be examined and measured.

8)

An analysis of the average capital growth of unit trust assets in the individual accounts using and not using the 'drip program', and the increased net cash flow to the investor in any and all accounts versus non income trust assets with straight dividend accumulation must be undertaken prior to making any conclusions that tie the individual investor and federal taxation policy that affects the individual net tax position together.

Moreover, every income producing security that goes in to Registered Retirement Savings Plan or tax exempt account could be viewed as 'tax leakage and a loss to current tax revenues

'.

9)

An analysis of net increased personal income taxes paid to the federal government must stand beside the corporate tax receipt increase paid to the federal government analysis for 2004 and going forward.

After reviewing the average effective corporate taxes paid between 2000 and 2004, the % is 27% and not the 35% rate used in the Dept. of Finance tables, and the dividend payout ratio of 27.5% is markedly less than the 100% payout ratio assumed in the analysis. (Gordon Tait, CFA, Nesbitt Burns, Oct. 3, 2005)

10)

The personal tax analysis must consider the potential forward going loss of revenue by creating a negative bias to this equity which could force liquidation, increased capital losses and further hurt issuer financing capabilities and personal tax revenue receipts to the federal government. Jobs may be lost, productivity will suffer.

11

) The analysis and consideration of lost corporate and personal income taxes to the government of Canada from all Canadian controlled offshore domiciled corporations and their shareholders, trustees, blind trust holdings and alike must be part of the 'tax for productivity argument". Any and all government leaders should not be allowed to own any tax exempt foreign domiciled Canadian companies which make their competitive advantage, a structural tax driven event – and all 'offshore domiciled' Canadian companies should be repatriated to level the tax burden for non offshore company's.

12

) An analysis of the federal government subsidy programs through the EDC and alike which create employment but no net productivity gains to the Cdn. Economy, through tax payer guarantees as in Bombardier, Nortel, etc. should be analyzed. The political arguments of the greater good theory form no part of this economic equation, only the philosophical debate and consequently should not be allowed to be confused with creativity increased productivity.

13

) An examination of internal income tax effectiveness of royalty trusts (the recent rise in commodity prices is expected to result in changes to 2005 corporate income tax % liability) with the expectation that the tax status of 2005 distributions to unit holders will be potentially fully taxable for Canadian income tax purposes to unit holders.

The implication is higher tax going forward paid to the government by unit holders.

Nebitt Burns' Gordon Tait, CFA concludes

: As deductions are used up, tax revenues grow. The direct analysis of income trust vs. public corporation taxes collected shows: $50.62 million dollars tax collected on distributions of $180 million vs. $31.6 million dollars tax collected on income of $100 million.

14

) All of the assumptions regarding leveling the playing field by changing the gross up to 150% instead of 125% and changing the federal and provincial tax credits in order to lower the top dividend tax rate to 24% presume that all end distributions to security holders are created equal or should be valued equally. When a structure's life expectancy is limited: by natural decline, external variables, economic market places or management, simply aligning tax rates accomplishes only that – aligning tax rates. The choices for investment opportunity will still be a function of the quality of yield spreads, not just yields taxed at the same rate - with a positive risk vs. reward scenario.

Therefore, personal and corporate tax harmony should be the key first objective.

15

) In order to equalize tax treatment between trusts and corporations, it is my opinion that corporate and personal income tax systems should be harmonized (i.e.: dividends and capital gains receive the same tax treatment) and all offshore domiciled Canadian companies should be repatriated and taxed in Canada regardless of where the operating business is deemed to be active, and registered.

Conclusion:

I argue that an independent, non conflicted analysis of corporate structure as it impacts productivity is also required. Moreover, the guarantee of the Canadian taxpayers to create productivity through manufacturing and sale guarantees of issuer debt (i.e.: Bombardier, and Nortel) demonstrates that preferential taxing and debt constructs to enhance a productivity result is not capital efficient nor productive. Arguably this is approach is a corporate subsidy and financial engineering program to keep a corporation alive through a government policy and intervention.

The trust structure has attracted more than 'it's fair share' of high capital/high growth companies and these have been among the most successful (i.e.: Fording, Riocan, Canadian Oil Sands, H&R Realty, Yellow Pages, Superior Propane, IPL, Fort Chicago, SIF.un and Connors Brothers). The argument that paying a high distribution forces increased the efficiency of management and economic returns is evidenced by the following points:

  • discipline is required to pay distributions so investments in marginal opportunities will require great commitment or avoided given the premise of paying distributions to unit holders, and management and directors have trustee oversight.
  • managers will take on a more conservative approach to debt (subject to investment bankers waiving checks, and issuers taking the money with no accretive use of proceeds)
  • CIBC Wood Gundy writes on September 6, 2005 in 'Market Conditions": "the entire premise of capital misallocation is unsound from a number of perspectives" and "the misallocation of capital into businesses, which are low growth and low profit, thereby creating inefficiencies that are detrimental to the Canadian economy" is a red herring issue.
  • The overall net tax effect when objectively measured with empirical data is: at worst neutral, at best net tax receipt gains to the Government of Canada especially.

Summary:

I believe that clarity of analysis and objective empirical research will produce policy that will not punish issuers that have converted to income trusts and flow through entities; and those income trust investors needing consistent tax efficient cash flow to supplement pensions, retirement funds, GIC's, Banker's Acceptance and other low yielding government securities. Those tax payers most in need spend the distributions to live – day to day and month to month.

Stewart Michael Lee
RR1, Ridgeway Ontario