November 25, 2006
More on the income trusts...
Income trusts in Canada: Death and taxes
Nov 2nd 2006 From The Economist print edition
The government cracks down on a stockmarket moneyspinner
OTTAWA - CANADA'S finance minister, Jim Flaherty, drove a stake through the heart of the fastest-growing sector of the Toronto Stock Exchange on Halloween, announcing a crackdown on income trusts that he said were being increasingly used by companies to dodge taxes. It was the latest attempt by successive governments to discourage corporations from converting to income trusts, which have become popular vehicles for shifting the tax burden from companies to investors. Judging from the dismayed reaction of the Toronto stockmarket, which plummeted the day after the news, his stake hit its mark.
Income trusts were first set up in the mid-1980s by mature property and energy companies who chose to pass on all of their profits to investors and thus avoid corporate income tax. At that stage the loss to the treasury was minimal. The haemorrhaging has increased during the past five years as businesses as diverse as pizza chains and telephone directories jumped on board, luring investors with higher but riskier yields than they could get from dividends or interest-bearing investments.
When two of the largest telecommunications firms in Canada — Telus and BCE (the owner of Bell Canada) — announced plans to switch to trust status this autumn, pushing estimated tax losses to more than C$1 billion ($885m) a year, the government could no longer sit idly by. Both companies said on November 1st that they were re-examining their options. But not before their shares dropped sharply.
For the government the problem is not so much individual investors, who hold about 39% of the 247 publicly traded income trusts worth C$200 billion. They pay personal income tax on the distributions. But cash going to pension plans, with 39%, would be taxed only in the hands of future beneficiaries. And foreign investors, with 22%, pay only a 15% withholding tax. Mr Flaherty plans to tax distributions of new trusts next year and those of existing trusts in 2011.
Although angry investors sputtered about the surprise announcement, citing Conservative campaign promises to leave the sector alone, the portents were all there. The previous Liberal government tried to limit pension investment in income trusts in 2004 but backed off when the pension industry objected. In 2005 it denied advance tax rulings to potential converts and then lowered the tax on dividends to make income trusts less attractive. All to no avail: there was another C$70 billion in announced conversions this year alone.
While you would not know it from the outcry, the trust sector was already beginning to fray around the edges as some of the riskier vehicles cut distributions and saw their unit prices fall. Small investors, who had been attracted by the promise of regular payments, had already begun to protest about them.
Is this truly the end? Some investors hope the government will reconsider and allow exceptions for the original energy and property companies. The more optimistic point out that 2011 is still four years away. A buying opportunity for some, a lingering death for the sector.
Copyright 2006 - The Economist Magazine