Corporate tax changes seen as option for income trust dilemma

(September 23, 2005) In light of Ottawa’s stern message earlier this week that it intends to clamp down on tax leakage to flow-through entities (FTEs), TD chief economist Don Drummond says the most likely solution is a decrease to the corporate tax rate and a rise in the dividend tax credit rate.

Ottawa could lower the general corporate tax rate to 19% from 21% (which, as the consultation document notes, would reduce the revenue loss to $135 million from $300 million) and reduce or eliminate the double taxation of dividends. And the feds could also raise the dividend tax credit rate to 23%, up from the current 16.7%.

The changes would reduce the revenue loss and the incentive to create FTEs. Some of the existing FTEs, he suspects would even consider switching back.

Still, another industry observer believes the government doesn’t really have a clear course of action. “I don’t think Finance has a clue what it is going to do,” says Jack Mintz, president of the C.D. Howe Institute.

His preference would be to see the integration of corporate and personal taxes, but that would require a big change to the system and would cost the government money. Other options include denying a deduction for borrowers so the interest becomes re-characterized as dividends or having a trust being subject to a corporate tax. But the latter two options would cause the greatest political destruction, says Mintz.

Implementing any changes, however, will be difficult since the government will not act until the consultation process ends December 31. Incorporating any decision into a 2006 budget — assuming the minority government doesn’t fall before then — given the tight time constraints is another challenge. And Drummond adds it is a very real possibility no action will be taken before the election, which will lead to more confusion in the industry.

In the interim, the decision by the Department of Finance to suspend advance tax rulings will likely prevent the tax leakage from growing much more as companies considering converting to an income trust shift their plans to the back burner. According to Finance’s consultation document the FTE market grew to $118.7 billion at the end of 2004 from $18 billion at the end of 2000. TD estimates the market today is around $175 billion.

But whatever happens, the government has made it abundantly clear that the status quo is not an option. The main question now is whether the new rules will apply to future conversions, with existing FTEs begin grandfathered. “I wouldn’t be so confident, as some of the trusts seem to be, that nothing will be done for the existing trusts,” cautions Drummond. It would be unfair to provide such a permanent advantage to a select group of companies, he adds.

If the government decides to sharply cut the taxation of dividends then the motivation of creating an income trust will have disappeared, he says. “Anyone can go ahead with a conversion if they want; but you just have to question the wisdom of doing so.”

Mintz isn’t so sure. In fact, he feels the government’s latest move could accelerate the number of income trusts as companies try to come out before the government changes its policy. “Governments always grandfather, the worse that will happen is that there be a phase out period.”

Political pressure will force the government to grandfather older trusts, Mintz explains. “There are a lot of people holding income trusts and it would be very difficult to bring down the hammer on older ones since it would destroy a lot of wealth and that is not a good thing in a minority government.

As for the consultation process itself, Drummond, who has participated in several over the years, expects this one will accomplish very little. “There are two things you can say about them: you very rarely learn anything you didn’t already know and secondly they immensely help you shape your communications about what you’ve probably already decided you are going to do.”

Which ever path government chooses, Drummond says the current challenges will cost Ottawa more to fix than it loses through revenue leakage. Based on the Department of Finance’s sensitive analysts, he estimates that figure is now about $600 million a year. Still, Drummond finds it hard to believe the cost to address this issue will be under $1 billion.

“That irony hasn’t been lost on Finance,” he says, “but the revenue loss is going to grow rapidly and at least for your $1 billion you buy a better tax structure and you solve some of your existing problems to boot.”

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