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Erica Procter'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:

TO:

Dennis Normand, Business Income Tax Division, Department of Finance

FROM:

Erica Procter

DATE:

 November 7, 2005

RE:

 The Debate Over Income Trusts

I am a PhD Student who has invested in income trusts to finance my education.  Naturally, I am very concerned given the uncertainty created with respect to the trust market and any legislation the Federal Government might impose that would reduce the value of income trusts.  In this regard, may I offer the following observations and suggestions.

1) The growth in the income trust market over the past several years has been beneficial to Canadians. 

2) There are some inequities in the current system that should be addressed. 

3) Solutions are available that will improve upon the current system while ensuring fair treatment of all parties, most particularly the individual Canadian investor.   

1) The growth in the income trust market has been beneficial to Canadians. 

Income trusts:

  • Provide an option for Canadian investors who seek a high level of current income while still accepting the business risk of an equity investor.  The Canadian government has long recognized the problem its citizens have providing an adequate level of retirement income – hence, the sponsorship of the registered retirement savings program.  However, interest rates today are exceptionally low.  Many retired Canadians or those approaching retirement did not plan on bond yields being so low.  Their retirement income, if generated from investment returns of only 3% or 4%, is far more modest than previously anticipated.  Income trusts have provided Canadians with an alternative – an opportunity to maintain a reasonable standard of living when retired from full-time employment. 
  • Provide an avenue to the capital markets that previously was not available to most small or mid-size Canadian companies.  It is the stable, mature, slower-growth company that is the ideal trust candidate but it is exactly for these reasons such companies have found access to the public market place difficult, if not impossible.  The high risk, growth capital markets continue to exist and thrive – the trust market simply provides an attractive alternative vehicle for the Canadian investor with a more conservative investment profile.
  • Have allowed Canadian businesses to be competitive bidders for acquisitions and fund internal growth projects, given their lower cost of equity capital.  Some business trusts have been transformed from small, stagnant entities into very dynamic growth vehicles, making value-enhancing acquisitions both here and abroad.  Canada has always had concerns about foreigners acquiring Canadian companies, moving head offices to a foreign jurisdiction and with the head office, the reliance on Canadian support services or research and development.  The reverse has been true in the business trust sector, with Chemtrade Logistics Income Fund being a prime example.  Chemtrade went public in June 2001.  At the time it was a wholly-owned subsidiary of Marsulex, a small Canadian company with a heavy debt load and very limited alternatives to equity financing.  The Chemtrade division had over seventy years of experience in providing removal services, primarily from Canadian mining facilities, but was exhibiting little or no growth.  Earnings before interest, taxes, depreciation and amortization (EBITDA) were $25 million in 2000 compared to $24 million in 1999 and $26 million in 1998.  However, over the subsequent four years, Chemtrade completed several acquisitions, not only in Canada but also in Germany and the U.S.  Today, EBITDA is more than three times the level of 2001 with approximately 40% being derived outside of Canada.  The total tax collected from the distributions paid by Chemtrade would surely now exceed the previous taxes paid by the total corporation Marsulex. 

2) There are some inequities in the current system that should be addressed. 

There is no doubt that the trust sector in Canada has grown tremendously over the past few years.  Even after the recent price correction, the total market capitalization of trusts exceeds $140 billion.  If trusts were included in the S&P/TSX Index, they would account for approximately 10% of the Canadian equity market. 

Ottawa has calculated a tax loss of $300 million per year and growing but the assumptions behind the calculations are critical as are the specific areas of where "leakage" and inequities exist.  In considering the current system, there are four main areas that should be addressed:

  • The conversion process
  • .  Canadian corporations that have converted to the income trust structure have experienced an immediate pop in market valuation so the incentive for others to contemplate a conversion is compelling.  For the long-term taxable investor, the gain is somewhat illusionary for he or she will, over time, pay a substantial tax on the distributions from the trust.  The gain is real however, for the short-term seller who finds it far more attractive to liquidate at the higher valuation, even though he or she may be subject to a capital gains tax.  Income trusts should not be an exit strategy for the corporate investor. 
  • The large corporation which already has access to capital markets.  The largest Canadian companies are primarily financial institutions, banks or life insurance companies.  Manulife had no difficulty acquiring John Hancock while TD Bank recently bought a controlling position in BankNorth.  Access to capital was not a problem. 
  • The dividend-paying corporation's investor base
  • given the double taxation of dividends.
  • Foreign investors that participate in the trust sector
  • .  Here, the concern of tax leakage has validity for the maximum tax collected is 15% versus the Canadian investor who is taxed at his or her marginal tax rate. 

3) Solutions are available that will improve upon the current system while ensuring fair treatment of all parties, most particularly the individual Canadian investor.   

We are certainly not tax experts but do recognize and appreciate some of the complexities of the Canadian tax system.  We believe what is paramount to consider is the impact on the individual Canadian investor.  Yellow Pages, the largest business trust in Canada, reported a unitholder base in excess of 100,000 Canadians, holding an average of 1,500 units.  Extrapolating to the total business trust market, it is very easy to conclude that over one million Canadians are currently participating in the sector.  In addition, many Canadians, either knowingly or unknowingly, have exposure to the trust sector through mutual funds or a company pension plan.  The typical, middle class Canadian who is saving for retirement is invested in the income trust sector and should not suffer from unexpected shocks to current tax legislation that would reduce the value of a trust or the net after-tax return from trust distributions. 

That said, changes that address the inequities in the current system have merit, most notably:

  • Instituting a higher tax at the conversion point from a corporation to a trust.
  •   If a trust investment is sold within a relatively short period of time after conversion, an additional tax should be levied.  This would limit the attractiveness of the conversion pop without penalizing the long-term investor in the trust sector.
  • Limiting the use and benefits of the trust structure to very large corporations.
  • Considerations include:
  • A structure that limits the conversion of corporations to trusts, particularly larger corporations
  • Different tax structures on new equity raised by existing trusts or a tax once a trust exceeds a particular size
  • A graduated tax based on size that would allow the small trusts to maintain their status while limiting the conversion of the larger corporation.
  • Modifying the corporate tax structure to address the double taxation of dividends.
  •   This would make the corporation-to-trust conversion less attractive and benefit the income-oriented Canadian investor.  The U.S. has the same low tax rate on dividends and capital gains.  However, any adjustment to place our Canadian companies on an equal footing internationally should not come at the expense of existing business trusts, which have clearly benefited Canada. 
  • Placing a tax at the trust level on distributions paid with an accompanying credit for
  • Canadians would enhance the tax revenue from foreigners while eliminating the tax discrepancy between the Canadian and foreign investor.

Other changes that have been suggested in the media are not appropriate, including:

  • Limiting the deduction of interest expenses.  Many corporations also rely on the deduction of interest to reduce their cost of capital, which in turn allows investment and growth that might otherwise not be economically feasible.  In addition, it would be somewhat arbitrary to penalize those trusts that use interest deductibility versus those that use a limited partnership, tax flow through structure.
  • Placing an additional tax on income trusts in the form of a distribution tax.  This would be very onerous, severely limiting any advantage smaller Canadian trusts may presently enjoy.  This would also greatly penalize current trust investors, most of whom have made investment decisions based on the current tax treatment of income trusts, which has been in place for many years.  Should real estate and energy trusts be excluded from any distribution tax, the onus would be solely on business trusts, a sector which in many cases is already suffering from high energy prices and a high Canadian dollar.  It is this manufacturing and retailing base that employs more people per dollar investment than probably any other in Canada. 

In summary, income trusts have and should continue to play a unique role in Canadian capital markets.  Slightly modifying the current system would appear to be far more favourable than severely hurting income-oriented investors when the tax loss, if any, is very modest.  Big companies do not need, nor should they benefit from, the income trust structure, nor should owners of a corporation seeking an exit strategy.  Foreigners should not have preferential treatment over Canadians.  The overall benefits of income trusts to Canadian investors, pension plans, small and mid-size businesses and their employees far outweigh any minimal tax leakage.