Tax cut needs provincial support

The markets may have applauded Ottawa’s decision to leave income trusts alone and instead lower the taxation of corporate dividends, but one economist says that doesn’t means the playing field is level between trusts and corporations.

The Department of Finance has been given a bit of a free ride, Don Drummond, TD Bank’s chief economist told a packed luncheon hosted by the Toronto CFA Society earlier this week, but upon further examination he says it hasn’t gone far enough.

As Drummond explains, the combination of increasing the gross up with the changes to dividend tax credits only takes the personal taxation of dividends from about 31% to about 26%. “You need to get it down to the 20 to 21% range to have neutrality,” he said.

While this addresses one problem, there are still two more pieces that must be addressed: the provincial response and foreign investors.

In their calculations to get the effective tax credit down to about 20%, the federal government assumes the provinces will more than double their dividend tax credit. So Ottawa is effectively assuming that the provinces will adopt a 13% dividend tax credit. “This is actually a larger proportional change then the federal government itself made,” Drummond said.

If the provinces don’t do anything, the traditional taxation of dividends will actually increase. “[The provinces] can’t just sit on the sidelines or the taxation goes up,” he says “so they have to make some response and hopefully they raise the dividend tax credit, but my bet is they won’t do it as wholesome as the federal government has assumed.”

With a full-blown election underway and the holiday season on the way it could be a while before we see any provincial response.

Income trust inclusion

Either way, income trusts are here to stay, but while they’ll soon be on the S&P/TSX Composite Index don’t looking for them on the S&P/TSX 60 anytime soon.

Standard & Poor’s doesn’t feel trusts are ready for inclusion on the more elite grouping — not yet anyway. “My personal guess is two or three years from now trusts will be on the TSX 60,” says David Blitzer, Standard & Poor’s managing director and chairman of the index committee.

The S&P will phase in income trust into the S&P/TSX Composite Index in two steps. The two step process is intended to allow investors time to adjust to the index.

The first change will coincide with the next rebalancing of the index, which is schedule to take place on December 16. The next step will take place on March 17, 2006.

Investors hoping to see a repeat of the index’s rally after Finance Minister Ralph Goodale’s announcement might be in for a bit of a disappointment, according to Blitzer. “My guess is there will be a fair amount of excitement on December 16, but come March there will be a little bit of an anti-climax.”

How do the tax changes really affect income trusts? Why are corporations complaining trusts still have an unfair advantage? Are trusts out of hot water? For a more in depth study of income trusts and what the tax changes will mean for these investments please look to the next issue of Advisor’s Edge Report, which will be mailed to subscribers in mid-December.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(12/02/05)