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Sprott Securities 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:
Sprott Securities Inc.
Specialty Income Trusts
Exploring The Alternatives On FTEs
What route will the Feds choose for Trusts And LPs?
In this research report, we look at the most likely scenarios that we believe will be pursued by the Department of Finance regarding the September 2005 consultation paper on income trusts and limited partnerships (LPs). In this report, we refer to income trusts and LPs as flow-through entities or FTEs. We will address the question of whether FTEs hurt Canada's economic efficiency. Secondly, after discussing the multitude of alternatives with our tax lawyers, we have boiled the potential resolutions down to three potential scenarios: (1) raise the dividend tax credit, (2) impose a tax on public business trusts and introduce a tax credit for taxable entities, and (3) reintroduce legislation that was proposed in the 2004 Budget to limit public business trust investments by pension funds, but this time encompassing all tax-exempt entities. Finally, we believe that the 2004 Budget proposal to apply withholding tax on all distributions to non-residents will be reintroduced.
Income trusts allocate capital as well or more efficiently than corporations.
Firstly, let's tackle the question of FTEs and their impact on economic efficiency. Over the last 200 years, stocks have generated a real return of about 6.8% per annum. However, it is a relatively unknown fact that 4.6% or about two-thirds of this return was derived from dividends (Michael Alexander. Stock Cycles. March 2000). But in the last few decades, investors in corporations have seen payout ratios and dividend yields decline, and the dependence has been overtly towards capital gains. Why should investors in a corporation accept little or no dividends? What if, contrary to popular belief, trusts are more efficient at allocating capital than corporations? We are in the camp that believes income trusts are very efficient at allocating capital as the free cash flow of an income trust (the cash flow remaining after maintaining existing assets) is paid to the trust's unit holders, instead of the trust investing in capital projects or making acquisitions that generate a rate of return that could potentially be less than its cost of capital. Simple economic theory tells us that capital should be diverted to investments that generate a rate of return that is higher than the cost of that capital. Thus, if a company has excess free cash flow and uneconomical investment projects, why not distribute the cash flow to its stakeholders instead of reinvesting the cash internally and destroying value? The goal of a corporation is, after-all, to maximize the value to its shareholders. This has been one of the key attributes of income trusts as this attribute has given investors the opportunity to save and direct the distributions received to more profitable endeavours. Where an income trust needs cash to fund an economically viable project or acquisition, it must typically go to the capital markets to approve and fund the investment by issuing additional units. From a theoretical perspective, the cost of raising additional equity is higher than the cost of using retained earnings. However, the theoretical perspective does not take into account the benefit to the shareholder of receiving cash (a dividend or distribution) at time zero along with the compounding effects of reinvestment, which may potentially outweigh the cost of raising funds externally. We believe that this model is the ultimate test of whether a project or acquisition that is proposed by management is truly worthy of investment dollars. Thus, we do not believe that FTEs hurt Canada's economic efficiency as FTEs allow capital to move more freely to where it will earn the highest return.
Potential solutions that address future tax leakage.
If the taxation of corporations and FTEs remains unchanged, we have no doubt that more corporations will be converted to income trusts as the arbitrage spread remains and the investor base continues to broaden with the inclusion of trusts in the S&P/TSX Composite Index. As the government indicated in its 2004 Budget, the government is not necessarily concerned about oil and gas trusts or REITs, but rather strictly focused on business trusts. Once again, we believe three solutions are the most likely: (1) raise the dividend tax credit, (2) impose a tax on public FTEs and introduce a FTE tax credit, and (3) reintroduce the legislation that was proposed in the 2004 Budget to limit business trust investments by pension funds, but this time have it apply to all tax-exempt entities.1. Raise The Dividend Tax Credit Or Lower The Corporate Tax Rate
According to the Department of Finance, dividends received from shareholders of public corporations are subject to an effective combined federal-provincial corporate and personal income tax rate of 49.6%, factoring in the benefit of the dividend tax credit of 13.33%. This compares to the average federal-provincial income tax rate on income trust distributions of 38%. Clearly, the higher effective combined rate on income earned through a corporation has partially driven the rise of income trusts.
Two solutions that have been proposed to reduce the tax arbitrage gap between income earned through a corporation and income earned through an income trust is to either increase the dividend tax credit or lower the corporate federal tax rate, thereby lowering the current effective combined tax rate on income earned through a corporation of 49.6% closer to the level of the 38% rate which applies to income earned through a trust. While both of these measures will close the tax arbitrage gap between corporations and trusts, we believe that the dividend tax credit will more directly target those corporations that have the ability to pay high levels of dividends and, as a result, are more likely to convert to an income trust, whereas a reduction of the corporate tax rate is broader and would also benefit companies that are not paying any dividends and may not be income trust material. An increased dividend tax credit would also encourage saving, which, in turn, would mean additional funds would be invested in the capital markets.
We are of the view that an increase to the dividend tax credit is the best option to pursue that would incorporate a tax reduction. And the federal government appears to be willing to give up some tax revenue. It attempted to cut federal corporate taxes in the 2005 Budget, but had to defer these plans to gain the NDP's support for the 2005 Budget. In fact, following the government's announcement that it would no longer provide advanced tax rulings in respect of transactions involving the conversion of a corporation to an income trust, and the resulting sell-off in the income trust market, Finance Minister Ralph Goodale said on September 28, 2005 that the federal Government is considering reducing taxes on dividends as a solution to the growing universe of business trusts. We believe that the only obstacle that could prevent the government from increasing the dividend tax credit is political, as an increase in the dividend tax credit may be perceived to be a tax break for the rich, and the minority Liberals need the support of the socialist NDP. Nevertheless, if the Government were to propose increasing the dividend tax credit as a solution to their study of FTEs in the 2006 Budget, at least corporate managers and investors will have guidelines to make decisions, and then the political process of pushing the policy through can follow.
2. Impose A Tax On Public FTEs And Introduce an FTE Tax Credit
The second proposal is to impose a tax on the income earned by public FTEs but provide taxable Canadian investors with a tax credit in respect of distributions received from the FTE. Notice that we have carved out public entities and left private entities untouched. The taxation of FTEs would be similar to Australia's tax on trusts that it enacted in 1981 and the United States' tax on master limited partnerships that was put in place in 1987. In addition, similar to the US, special rules would apply to FTEs whereby if 90% of their revenue is passive (resource or real estate income), oil and gas trusts and REITs would be exempt. The unique aspect of our proposal, however, is the tax credit for taxable investors to ensure that double taxation does not take place for FTE investors.
The goal would be to tax income earned at the corporate and trust level at the same rate so that equal amounts of tax would be collected before any distributions were made. Taxable entities resident in Canada that receive a distribution from a trust would then be entitled to a tax credit, just as taxable investors of corporations receive a dividend tax credit. Tax-exempt entities and non-residents that receive a distribution would not be eligible for tax credits, thus, eliminating the potential of future tax leakage.
While this proposal would near equalize corporations and trusts in the way they are taxed at the corporate/trust level, we believe that any tax on FTEs in general would be seen as a tax grab – an unwelcome move from a government looking to retain its standing amongst voters and also regain ground lost to the right-wing Conservatives. Furthermore, the billions of dollars that have already been lost as a result of market uncertainty will multiply as the affected trusts have their valuations slashed further to reflect the elimination of future tax savings. While it is likely that the government would grandfather existing trusts under this circumstance, how can external growth of the existing trusts be controlled and does the grandfathering last long enough to eliminate the present value impact of the tax savings. Finally, under the trust taxation scenario, business trusts could simply opt to reorganize as Income Participating Securities (IPS) or the like, which do not have trusts or LPs and instead pay interest and dividends directly to the investor.
3. Reintroduce Limits On Business Trust Investments By Tax-Exempt Parties
With reference to our March 24, 2004 Morning Note, the Government's 2004 Budget Plan included a proposition to limit investments by registered pension plans in public business trusts to 1% of the book value of the fund's assets. Pension funds would also have been limited to holding no more than 5% of any (one) business trust. Existing investments by pension funds would have been given transitional relief from penalties for the next 10 years for direct business trust holdings and 5 years for indirect fund-of-fund holdings.
However, on May 18, 2004, in response to stakeholder concerns about the impact of these proposals on pension fund investment, the Government suspended the proposals to allow for further consultation. The concern of pension funds was that they would be put on unequal footing, especially relative to other tax-exempt plans, such as RRSPs and RRIFs.
Our final scenario would see the reintroduction of this proposal, except that this time it would cover all tax-exempt plans. Thus, a limit would be placed on the percentage of any tax-exempt entity's portfolio that could be invested in business trusts or fund-of-funds invested too heavily in business trusts, what the government referred to as "restricted investment properties." In its consultation paper, the government even went as far as to provide a sensitivity table (Figure 1) to demonstrate the sensitivity of changing the government's estimate that 39% of FTEs are held by tax-exempt investors relative to the average effective federal corporate income tax rate of 6.3% as a percentage of EBITDA. Using these coordinates, the government estimated that $300MM was the tax leakage.
Figure 1: Sensitivity Of Estimated Impact on Federal Tax Revenues to Key Assumptions ($MM, 2004)
Source: Department of Finance Canada
The government estimates that 39% of FTEs are held by tax-exempt plans. Keep in mind, however, that business trusts are likely to be singled out and that the government estimates that tax-exempt entities hold 45% of business trusts. In any case, the government would need to provide transitional relief as it proposed to do in 2004. For example, beginning in 2007 registered plans cannot hold more than 40% of its book value in business trusts, in 2008 the limit drops to 35% and so on until we hit the long-term percentage. Furthermore, this limit is now more plausible as tax-exempt entities no longer have foreign content restrictions, meaning that the potential addressable investments of a tax-exempt entity are now much larger than they were last year when the pension fund investment limit was initially introduced. To put it into perspective, full global investment is now possible for tax-exempt entities, Canada's stock markets represent 3% of the global capitalization and income trusts are 11% of the Canadian market, which means that income trusts represent less than 0.5% of a tax-exempt entity's investment options.
Since taxable entities will continue to pay taxes on trust distributions, any future potential tax losses (both federal and provincial) from tax-exempt entities is limited. Further, imposing a limit on tax-exempt entities investing in business trusts would likely deter many larger capitalization corporations that may need support from the entire investment community from converting to income trusts. On the other side of the coin, this could result in interests in many open and closed end funds that currently invest in business trusts being classified as restricted investment properties. Furthermore, some argue that there continues to be a lack of income-generating investments for aging boomers and this proposal could further limit their options. Finally, it is also argued that the investment in business income trusts by tax-exempt entities is simply a timing issue, and that additional tax revenue (which has not been accounted for in many of the "tax leakage" studies) will be generated when these tax-exempts entities distribute amounts to those that hold interests in them.
What is the solution to taxes leaving the country?
The government is also looking to limit the future leakage of taxes leaving the country to non-residents. As a backgrounder, an income trust's distribution could be comprised of interest, dividend or return of capital (commonly referred to as a tax-deferred distribution). Currently, a 25% withholding tax (reduced to 15% for countries with tax treaties with Canada such as the US) is applied to only the interest and dividend portions of those distributions, whereas tax on the return of capital cannot be captured from non-residents. Return of capital is used to reduce the cost base of the investment, which only results in a taxable event when the investment is sold, and is also only taxable in the non-residents' country. We believe that the government will move to reinstate its 2004 Budget proposal to apply the withholding tax to the entire distribution of publicly traded trusts, instead of just the interest and dividend portion previously. Furthermore, with this more comprehensive review of all FTEs, the government may also opt to cover publicly traded LPs along with income trusts. This will largely impact publicly traded REITs, LPs and oil and gas trusts where a larger portion of the distribution is return of capital or tax-deferred compared to business trusts, where the majority of the distribution is interest (Figure 2). With this change, we believe that the government should eliminate the rule on these publicly traded FTEs that at least 51% of the owners are Canadian residents, as it is now capturing withholding tax on all distributions to non-residents.
Figure 2: Summary of Composition FTE Distributions
Source: Department of Finance Canada
We believe that this consultation will result in a long-term plan and not a short-term band-aid effort, which we support as the market deserves to have the uncertainty eliminated for the long-term, resulting in businesses and investors having the tools to make the most-informed decisions. The facets of this long-term conclusion in our minds should include:1. Increasing the dividend tax credit,
2. Implementing a phased-in limit on tax-exempt entities' investments in publicly traded business trusts,
3. Implementing a withholding tax on 100% of the distributions to non-residents from publicly traded FTEs,
4. Eliminating the requirement that publicly traded FTEs be at least 51% held by Canadian residents.
While the government will be giving up tax revenue via the dividend tax credit, it will also begin capturing additional revenue via the new withholding tax on non-residents. We recognize that there will be parties that will oppose these measures, however, we believe that these are the most fair and prudent set of measures that ensures that any potential tax leakage is contained, while at the same time ensures that the income trust market can continue to function without an impact on current market valuations. At the same time, it will likely result in large public corporations thinking twice about converting to a trust as the income trust investor base under the new rules may not be large enough to support its size and intended valuation.
What Would The Market Impact Be?
Given the above conclusions, we do not believe that trust valuations would be impacted negatively as described in the corresponding arguments:
1. Increasing the dividend tax credit will make corporations more valuable on an after-tax basis and should not negatively affect trust prices,
2. Phasing in of the limits on tax-exempt entities will ensure that there are controlled dispositions over time that should not negatively impact business trust prices. Other FTE pricing should not be impacted. Tax-exempt plans looking to a benchmark for guidance can follow the new S&P/TSX Equity Composite Index that will not included income trusts.
3. Implementing a withholding tax on 100% of the distributions to non-residents will decrease the after-tax yield that non-residents are earning, however, these yields will still remain attractive relative to the alternatives that are currently available. Furthermore, we have always stressed that trusts should be valued similar to equities based on methods that also take into account the retained cash flow such as EV/EBITDA, P/CF, P/FCF or discounted free cash flow,
4. Eliminating the requirement that publicly traded FTEs be at least 51% held by Canadian residents should not impact trust valuations. Instead, it eliminates the "glass ceiling" that previously existed for non-resident investors.
While we believe that our view provides a comprehensive solution, we have no doubt that the income trust market will continue to experience volatility until the government provides some guidance or a plan on the future of income trusts in Canada. Nevertheless, we believe that under any scenario, current trust market valuations will not be negatively impacted as any new rules will be phased-in and/or the current publicly traded FTEs will be grandfathered.
As it applies to proposed conversions from corporate to trust structure, we remain cautious as an increase in the dividend tax credit and/or a limit on tax-exempt entities' investments in business income trusts may alter the decision to proceed. For long-term taxable investors, we continue to believe that investors should be using periods of weakness to buy the high-quality trust names that we believe offer attractive risk/reward propositions as highlighted in our Specialty Income Trusts Weekly.
I, Aleem Israel, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject company(ies) and its (their) securities. I also certify that I have not been, and will not be receiving direct or indirect compensation in exchange for expressing the specific recommendation(s) in this report.
|Sprott's recommendation terminology is as follows:|
|Top Pick||our best investment ideas, the greatest potential value appreciation|
|Buy||expected to outperform its peer group|
|Market Perform||expected to perform with its peer group|
|Reduce||expected to underperform its peer group|
Our ratings may be followed by "(S)" which denotes that the investment is speculative and has a higher degree of risk associated with it.
Additionally, our target prices are set based on a 12-month investment horizon.
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