The deal with Income trusts
Posted in Commentary on November 2nd, 2006 by Sacha PeterThe reason why the government changed the rules on income trusts was because of something called tax leakage. Normally when a company makes money, they pay taxes to the government as a fraction of their income. The rest of the money they could invest in their own business or give to their investors in the form of a dividend. Investors are taxed on this dividend, which results in something called double taxation. The Canadian government taxes dividend income a little less than ordinary income, but the net result is that the money which changes hands twice, is taxed twice.
Income trusts bypass this. When a company that is formed as a trust makes money, they distribute all their profits to the people that own the trusts. The company doesn’t have to pay taxes on these distributions – instead the people that receive income from the trust treat the money as income (there are some rules with respect to this that may result in some of this being deferred or otherwise, but for the most part it is income).
As a result, this income is taxed only once – in the hands of the investors. This tax that gets paid is less. In theory, this tax should be comparable to the taxes that would be paid if the company had to pay corporate taxes, but it turns out to be far less. I will go through a few examples.
Example 1: If the investor holds the trust inside his/her RRSP, they don’t have to pay any taxes until they withdraw that money from their retirement savings plan. Only when they take the money out of their RRSP is this money taxed as ordinary income.
Example 2: Pension plans and other tax-sheltered financial instruments can invest in income trusts and generally don’t have to pay taxes on the distributions. Eventually these pension plans have to distribute their gains back to investors, and this is taxed as ordinary income.
Example 3: Foreign owners of income trusts can receive distributions but don’t have to pay taxes on it, or at least pay a smaller withholding tax. Foreigners will never pay more taxes than that on trusts.
One obvious way to stop the tax leakage is to stop foreign ownership of income trusts. Right now, up to 49% of a trust can be held by foreign owners. One easy way to stop this is to legislate a maximum of 2% or some nominal amount of foreign ownership. This would reduce the investment demand for such products and make sure that the tax that otherwise would have been collected with business taxes will eventually get collected.
The reason why income trusts were so popular is because entities like avoiding paying taxes if they didn’t have to. There was a demand for the product and it was being filled, especially in the low interest rate environment of 2003-2004.
One disadvantage of the income trust structure is that corporations were restricted to using retained profits for capital investment – if they gave out all their cash to their owners then there would be nothing left for reinvestment. This is what the Government of Canada was worried about.
There were no easy solutions with the income trust issue – personally, I would have preferred to see governments making dividends tax deductible for business income tax purposes.
Please read and comment on the following article, I would appreciate your opinion.
“Canada: Two Wrongs Don’t Make a Right”
http://www.informit.com/articles/article.asp?p=673519&rl=1
“Canada: Two Wrongs Don’t Make a Right”
“It is amazing how governments and legislators do not take into account the role of incentives in economic decisions. Ignoring incentives leads to what many politicians call unintended consequences of their policy actions. But that’s not all. Once the unintended consequences are identified, instead of choosing the simple direct solution, more often than not these same politicians choose convoluted and more complicated solutions to the problem. One such example is the recent decision by Canadian authorities to eliminate the differential taxation between incomes generated by corporations and publicly traded flow-through entities (FTE). The recent experiences of our neighbors north of the border have some interesting implications for the U.S. financial markets in the aftermath of the recent elections. In order to bring everyone up to speed with our neighbor’s recent events, some background information is in order.”
I can’t comment on this in a single paragraph – the issue is sufficiently complex that a single news-bite isn’t enough to cover all the bases.
The fundamental issue here is one of taxation of the individual vs. taxation of the corporation. Layered in that are the two different ways both entities can be taxed. Essentially if all income trusts were wholly held by residents of the country, this argument would be moot. Within our existing tax framework, that’s probably the “easiest” solution.
More complex solutions lie in overhauling the income tax act. Specifically this involves the words “flat tax” and such words are so politically dangerous that the Conservatives would probably lose their minority government in a heartbeat if they mentioned it.
But think how corporate taxation would work if there was no difference tax-wise concerning a company’s capitalization whether they choose equity or debt – right now debt is highly tax favoured while equity is not. Tie this in with income trusts, and you’ll quickly understand why this isn’t a “quick response” type issue and why most of the newspaper editors have no freaking clue what they’re talking about.