Canadian income trusts re-examined

In my blog on November 1, I discussed Canada’s decision to tax income trusts for the first time and raise dividend tax rates for pension funds and foreign investors that own trusts. I said the move strikes a blow at the companies structured to offer high-yield securities that have flourished in Canada, but simultaneously strikes a blow at retirees who have sought cash distributions to boost their retirement incomes.

I went on to opine that Canadian socialism still prevails, noting that some retirees who’ve depended on the tax-free distributions from income trusts will find their incomes dropping, will now stop investing in free-enterprise corporations, and find it easier to demand more subsidies from the welfare government.

In a thoughtful reply to the blog, a Canadian reader, Mr. M.S., pointed out that there was more to the trust-taxation change than I had perceived, and suggests that the move toward socialism in Canada is actually slowing down, if not reversing. He writes:

Although your take on socialism in Canada is mostly right, you are wrong about the direction. The current government is trying very hard to reduce the size and dependence on government. They have reduced federal sales tax called GST, and are planning a further reduction. They have reduced spending in certain completely unproductive but politically correct areas and have eliminated related programs.

Their stance on the income trust issue is correct for a couple of reasons. First of all income trusts and related tax treatment were badly conceived. Trust payouts are an alternative to dividends but with more favorable tax treatment. However the related regulations virtually eliminate any retained earnings. [the law requires all income be distributed. Ed.] Since their introduction more and more companies have converted to income trusts in order to receive this tax treatment. This has produced a capital-market anomaly by distorting the cost of capital between the two business models.

Ordinarily this would not be a bad thing. However, in this case the resulting behavior is that businesses operating under the trust model have little appetite for risk or innovation, and are dependent on acquiring assets to replace those depleted, in the case of resources. And to make these acquisitions they must issue more capital. Thus most businesses become more like consolidators, rather than engaging in much organic growth. They are managed for efficiency rather than effectiveness. Their piece of the economic pie was growing as more companies were converting to trusts. They were stifling innovation and productivity.

My initial reaction when the income trust matter came up was that the solution should have been to level the playing field by reducing the tax on dividends at the corporate level. And combining it with a change in the withholding tax. More on that below. But that would have required changes to international tax treaties, which I am sure was going to be a losing proposition.

The other reason that their stance on trusts was correct was another unintended consequence. Withholding tax on certain foreign investors, including those from the US was only 15%. Thus there was considerable tax leakage because of the numbers of foreign investors participating, as well as the numbers of non-tax entities such as pension funds. Consequently foreign investors received better tax treatment than Canadian unit holders. And particularly in the case of oil and gas, little extra incentive is needed to attract investors at today’s energy prices. I wouldn't ordinarily worry about tax leakage, however, Canada needs to invest billions to bolster its deplorable military capability.  From a nation with almost 1 million men and women serving during world war 2, and with a population base of about 20 million, we can barely muster an effective fighting force of 5000 today. And in Afghanistan we are getting badly hurt because we don't have transport helicopters. The previous government sold them as unnecessary. Our military is a joke and a national disgrace and must be rebuilt.

Letting the military degenerate into being a national disgrace was surely a socialist direction. Rebuilding it, which the current government has promised to do, is a reversal of that direction. It is one of many steps currently being taken. I agree they are small, and there is a long way to go.

Thanks for taking the time to respond, M.S.. I greatly appreciate the explanation, and certainly cheer any move in the direction away from socialism. Such a path is devoutly to be wished.

Favorable tax treatment for holders of income trusts has definitely segregated the capital markets, directing those seeking income toward the trusts, and those seeking capital gains toward conventional equities. It would seem that the system more efficiently divides the market into two asset types, those that offer regular income at low tax rates, and those that offer capital gains. Thus, retirees can focus their portfolios on income, which is what they need, and the younger investors can direct their capital toward companies that need it to expand and grow.

As the market gradually segregates between growth and income, investors benefit and Canada loses tax revenue, which is why the law is changed.

It would seem to me that the capital-market anomaly created is a positive evolution for the marketplace, allocating capital more efficiently, according to the need of the investor, and the nature of the business. It happens, of course, because individuals and corporations always try to minimize loss through theft (i.e., taxation). It also happens because it’s more efficient for investors.

The question of whether Canada would be better off with more tax revenue in order to expand their armed forces is an issue open to debate, and one I shouldn’t delve into here. I still take the rather odd position that while I’m against taxation, since it’s theft by force, I’m even more against deficit spending, since it’s theft by fraud. The real objective, given that government will spend money, is to make it balance it’s budget by meeting all expenses through taxation, and none through borrowing.

The ultimate answer that solves every segment of this tangle is to achieve a society in which taxes don’t exist because all products and services are privately produced, and all government is self government. It’s a world of sovereign individuals.

Comments

[Del]

I got to say Canada does not need a military. What a waste for them, to pump their ego like that. They are in the unqiue position of not needing one and should be happy with a strong national police force to defend their country. And I'm not a dove. I wish the USA would just kick ass and be done with it, let the world cry when we're done. But that's not going to happen, case closed.

[Geoffrey Laxton]

Who is Gwyn Mogan and Murray Edwards?

If the NDP considers Gwyn Morgan unsuitable for Public Appointments Commissions Chair, why is he good enough for the NDP to be the source for Harper and Flaherty's misguided income trust taxation policy?

Here is an interesting area of inquiry for analysis concerning who bent Harper and Flaherty's ear concerning income trust taxation.

"The energy trust debate has resulted in some recrimination in Calgary. Mr. Dielwart suggested yesterday that former EnCana Corp. CEO Gwyn Morgan, who did not support his company's secretive discussions to convert part of its business to a trust, helped sway Prime Minister Stephen Harper's thinking on the issue. Mr. Morgan stepped down from the board in October.

Mr. Dielwart also pointed a finger at Canadian Natural Resources Ltd. vice-chairman Murray Edwards, another trust critic.

"The Prime Minister and the Finance Minister, in my opinion, have placed great faith in these individuals," he said. "Does Gwyn believe he was telling Flaherty and Harper the right thing? I'm sure he does. But he's out of touch with reality."

Neither Mr. Morgan nor Mr. Edwards could be reached for comment."

*****

Who is Gwyn Morgan?

http://www.ndp.ca/page/3745

Government Operations Committee rules Morgan “unsuitable” for Public Appointments Commissions Chair
OTTAWA — After hearing from Prime Minister Harper’s hand-picked choice for the new position of Public Appointments Commissions Chair, the Public Accounts committee has rejected former Encana CEO Gwyn Morgan, deeming him “unsuitable” for the post.

Morgan repeatedly refused to apologize for offensive comments he made about immigrants, low-wage workers and unions in a speech he gave several months ago.

“Mr. Morgan’s comments were deeply offensive, insensitive and out of step with Canadian values,” NDP MP Peggy Nash (Parkdale-High Park) said. “He had the opportunity to withdraw and apologize for his remarks to demonstrate to us his suitability. He refused; so we acted.”

Nash moved the motion at the Government Operations and Estimates Standing Committee calling on Prime Minister Harper to withdraw his nominee for Public Appointments Commission Chair.

“The Prime Minister must recognize the democratic will of the committee and recognize the unsuitability of his choice. He should publicly withdraw this nominee immediately.”

In December of 2005 Morgan addressed the Fraser Institute Forum and made controversial remarks about Asian and Jamaican immigrants to Canada and their supposed propensity for violence.

Mr. Morgan also attacked low wage workers, auto sector unions and the New Democratic Party in the same speech. Nash believes that such a deeply partisan and ideological person should not serve in a position that is meant to stem the tide of partisan patronage appointments.

*****
Here are Gwyn Morgan's words on the income trust issue published by the Globe and Mail:

http://www.theglobeandmail.com/servlet/story/RTGAM.20061102.wcotrust02/BNStory/specialComment
Commentary

In the long term, Ottawa is right to move on income trusts
Governments, particularly minority governments, just don't do such things, do they? Yes, they do, businessman Gwynn Morgan opines. Stephen Harper already has demonstrated that his government will put principle ahead of politics.
GWYN MORGAN

From Thursday's Globe and Mail

When I was asked to write about Tuesday's income-trust announcement, my first reaction was that there is much more downside than upside in wading into these financially and emotionally roiling waters.

If doing so requires just an ounce of courage on my part, then the courage required by Jim Flaherty must be measured in tonnes. And this goes for his boss, Stephen Harper, as well.

In one decisive move, the Conservative government has riled trust investors, fund managers, trust executives and employees, along with the investment bankers, lawyers and others who have made a lot of money facilitating a huge shift from the corporate model to the trust structures. Their reaction is bound to be both immediate and visceral.

On the other hand, it's hard to think of many whose immediate reaction will be greatly positive.

The reason, of course, is that the first group will immediately lose money, while the rest of Canadians will see no direct impact on their lives.
So the Harper government has unleashed a torrent of criticism, including that of the opposition Liberals, who can correctly accuse the Conservatives of reversing course from their election rhetoric.

Governments, particularly minority governments, just don't do such things, do they?

But, then, Mr. Harper already has demonstrated that his government will put principle ahead of politics.

So what is the principle that he believes is important enough to upset quite a number of the people who voted for his party?

Mr. Flaherty says that, were Canada to move to an "income-trust economy," three negative consequences would result:

1. Tax leakage, reducing overall government revenues.

2. Tax imbalance, shifting more and more of this burden to individual taxpayers.

3. Lowered national competitiveness, with income trusts' cash payouts reducing R & D and reinvestments in new technologies.

Is he correct?

On tax leakage, the answer is yes, but not in the way you might think.

Individual Canadian investors would largely have made up for tax avoided in the trust structure by paying tax on cash distributions. Even those holding trust units in tax-deferred accounts would, sooner or later, pay the piper. Very little long-term leakage here.

But, for foreign investors, Canadian trusts have been a tax bonanza. This is because, except for a minimal withholding tax, the cash payouts are pretty much tax free. This is where the real leakage is occurring, with foreigners getting a free ride from Canadian taxpayers.

At the federal level, most of this leakage is made up by higher capital gains tax inflows from trust conversion; the real leakage occurs at the provincial level.

As for the second point, tax imbalance, most Canadians don't understand that, whether it's a corporation or a trust, business income taxes are eventually paid by the owners of the business. In the case of publicly traded corporations, that's the shareholders.

The more highly taxed the corporation, the lower the dividends and capital gains for the shareholder, and the less tax paid by the shareholder. In other words, they pay the tax indirectly, rather than directly. In principle, the trust structure makes a lot of sense, because it places the tax burden on real people, the owners.

The third possible consequence, national competitiveness, is the most important concern.

Canadian business drives economic wealth through employment, economic development and investor value creation. The shareholders and employees of Canadian businesses provide the funds needed to run government programs and services. Therefore, research, reinvestment and growth are crucial to the future living standards of all Canadians. To the extent that trusts may have limited these things, the government had reason to be concerned.

Of course, the trust phenomenon would never have gained such momentum if Canada's corporate tax rates were competitive with those of other countries.

The government's sense of urgency, no doubt, was brought to a head by proposals to convert Canada's two largest telecom icons, but it is fair to say that Canadian directors and management teams have increasingly been faced with shareholders who are demanding to know why their corporations were not converting to a trust.

If, as Mr. Flaherty predicts, inaction would have resulted in "an income-trust economy," then taking action is certainly in the longer term interest of Canadians.

Gwyn Morgan is the retired founding CEO of EnCana Corp.

*****

http://www.encana.com/investor/news_releases/news_2006/1025-2.html

http://www.thecanadianencyclopedia.com/index.cfm?PgNm=TCE&Params=M1ARTM0012432

http://www.cbc.ca/canada/story/2006/05/16/morgan-rejected.html

[Geoffrey Laxton]

One problem concerning the Government's analysis of income trusts is that they are using a top down approach. Instead of asking why certain industries need a lower cost of capital to actually exist, the Government is in effect saying that lower cost of capital is unfair.

[Geoffrey Laxton]

When Gwyn Morgan says:

"But, for foreign investors, Canadian trusts have been a tax bonanza. This is because, except for a minimal withholding tax, the cash payouts are pretty much tax free. This is where the real leakage is occurring, with foreigners getting a free ride from Canadian taxpayers."

What he is saying is that the 15% tax that US investors pay is too low. What he doesn't say is that Canadians holding foreign and US securities as per proper diversification harpers, also pay 15% tax as per international tax treaty. He also doesn't mention that US investors provide an important source of capital to the Canadian Markets, creating liquidity. Also, US investors do not use Canadian social programs such as health care.

The whole problem is that Canadian's pay too much tax!

[Geoffrey Laxton]

According to Gwyn Morgan the major advisor to Harper and Flaherty on the taxation of income trusts he actually admits that individual Canadian investors are not a tax leakage!!!

"Individual Canadian investors would largely have made up for tax avoided in the trust structure by paying tax on cash distributions. Even those holding trust units in tax-deferred accounts would, sooner or later, pay the piper. Very little long-term leakage here."