Tax on income trusts is likely here to stay

OTTAWA — The House of Commons Finance Committee has voted down a measure that would have provided for a 10-year delay in taxing companies with an income trust structure. Pending an election, the May 30 vote spells the end of a long battle against the new 31.5% tax on income trusts announced Oct. 31 by the minority Conservative government’s finance minister, Jim Flaherty. The tax touched on the very rationale for income trusts, which pay profits out directly to investors and thus avoid most corporate taxes (InvestmentNews, Jan. 22). Mr. Flaherty’s measure applied immediately to any new trusts but gave a four-year moratorium — through 2011 — to established trusts. The Conservatives, who took power in January 2006, have 125 of the 308 seats in the House of Commons. But in the committee, the Liberals and the Bloc Quebecois have six votes between them, while the Conservatives and New Democrats have just five — plus the Conservative chairman, who votes only to break a tie. Those soldiering on in support of income trusts were given hope Feb. 28 when the committee embarrassed the government by releasing a report slamming the new tax as “devastating,” and suggesting that it be scaled back to 10% and that the government should extend a tax-free grace period for established trusts to 10 years. The committee Conservatives produced a dissident report. “We respectfully submit that the Finance Committee follows its own advice to the government earlier this year in its report on income trusts by producing a separate piece of legislation that is comprehensive and includes the guidelines and conversion rules — and is not so broad as to have application to partnerships that are not listed on a public exchange,” George Kesteven, president of the Toronto-based Canadian Association of Income Funds, told the committee May 28. Evidently, such legislation isn’t forthcoming. Income trusts are doing better than expected in the wake of the tax. In the six-month period ended April 30, the S&P/TSX Capped Income Trust Index was down just 3.6%. True, that loss occurred despite a robust 10% gain for the S&P/TSX Composite Index over the same period. “There is no need to alter the income trust tax amendment … based on developments since the Oct. 31, 2006, announcement of the new income trusts tax,” Diane Urquhart, an independent consulting analyst based in Mississauga, Ontario, told the committee May 29. “The business income trusts that had stumbled badly before the Flaherty income trusts tax announcement have not recovered.” Ms. Urquhart also focused on foreign ownership. “It is grossly unfair to permit foreigners to acquire income trusts with the intent to pay no Canadian business taxes, when the same tax advantage was taken away from individual Canadians … Plus, why does Canada want to provide a tax incentive for foreign takeovers of its Canadian-owned businesses?” Ms. Urquhart said. Foreign interest is strong. “I think we’re just seeing the tip of the iceberg,” income trust experts from Guardian Capital LP, a Toronto-based investment management organization, wrote in a jointly written article published in May on the firm’s website. “We expect a lot of M&A activity as we go forward in time. The reasons are pretty straightforward,” the Guardian experts said. “Think about the attributes that we want in an income trust; we want stable and predictable distributions. Income trusts are all about cash flow,” the article said. “We want strong franchises, good asset bases, solid management and low debt for a lot of financial flexibility. That’s what income trusts are all about,” it said. “That’s also what global private capital is all about — they want long-duration, predictable, sustainable cash flow,” the Guardian experts said. “What’s the link here? Well before October 2006, income trusts used to trade at a valuation premium somewhere between 25% and 35% in most sectors of the trust market,” the Guardian experts said. “That valuation premium has been taken away. So a year ago, income trusts wouldn’t be in the sightlines of private-capital players; now they’re front and center,” the Guardian experts added. Ms. Urquhart suggested two measures to deal with unwarranted foreign interest. “The only action required now is for the Canada Revenue Agency to announce its plans to use the general anti-avoidance rule and the thin-capitalization rules in the Income Tax Act to ensure that acquirers of income trusts will be paying Canadian business taxes,” she wrote last Monday in an e-mail to Mr. Flaherty and William V. Baker, commissioner of the Canada Revenue Agency in Ottawa. “This must be done so that individual investors are treated fairly compared to pension funds, private-equity funds, corporations and U.S. master limited partnerships,” Ms. Urquhart wrote. “If [the general anti-avoidance rule] and the thin-capitalization rules are enforced, foreign acquirers do not have a Canadian tax incentive to take over Canadian income trusts.” However, “thin-capitalization rules only apply to corporations, not income trusts,” and the anti-avoidance rule is intended for deliberate schemes to skirt taxes, said Len Farber, a senior adviser on tax with Montreal-based law firm Ogilvy Renault LLP. “New measures, new legislation would be needed to stop private equity.”