The Canadian government's announcement concerning the tax treatment of income trustsLinkedIn
There, in black and white
Bulletin NB Vol. 9 N. 10, December 2006
The Canadian government recently made the decision to amend the tax treatment of income trusts to close a breach that leads to the loss of significant tax revenue. Indeed, Canadian companies set up as income trusts do not currently pay corporate taxes. They rather hand out most of their income to unitholders, who then pay tax on these distributions. Combined with the tax exemptions granted to non-taxable investors, such as pension funds and RRSPs, these provisions provide governments with very little tax revenue from the income generated by income trusts, which results in annual losses of hundreds of millions of dollars in income tax collected.
Interest in income trusts has been on the rise ever since the principle of unlimited liability applicable to income trust unitholders was abolished in 2004 and 2005. Since the beginning of the year, there have been nearly $70 billion in new trust announcements. In an effort to put an end to this wave of conversions, the Minister of Finance, Jim Flaherty, announced on October 31, 2006 measures intended to eliminate the tax advantage of income trusts. With certain opposition parties already on board, this proposal will almost certainly be adopted.
Thus, all income trusts created on or after November 1, 2006 will see their distributions to investors taxed at the source, as is the case with business corporations. Existing income trusts will be granted a four-year transition period during which they will remain tax-exempt, and will not be subject to the new measures until 2011. It should however be noted that real estate investment trusts (REITs) will not be affected by these measures provided that they meet certain criteria that will nevertheless be tightened. With respect to taxable investors, distributions received will now be subject to the same tax treatment as dividends from business corporations.
From a strictly tax standpoint, the announcement has a discernable impact on the distributions received by tax-exempt investors (in particular pension funds and RRSPs) and foreign investors. Distributions from income trusts will be taxed directly at the trust level, at the same rate as the one applicable to corporations. As for the profits not distributed by income trusts, they will be taxed at a higher rate than the corporate tax rate. Not only will this eliminate any tax-related reasons for adopting an income trust structure, it will also make it truly disadvantageous to maintain such a structure.
Minister Flaherty’s announcement shook up the Canadian financial markets. The income trust sector of the Toronto Stock Exchange lost more than $20 billion in market capitalization on November 1, the day after the announcement was made, which represents close to 12% of its total value. On that day, some income trusts suffered losses of up to 25% of their share value. Companies that were planning to embark on a trust conversion in the near future also took a hit. BCE and Telus shares were down 11% and 14% respectively by the end of the day.
Energy income trusts, which account for close to 60% of the market capitalization of the S&P/TSX Income Trust Index, were a key factor in the losses experienced, plummeting 13% on average following the announcement. Real estate investment trusts, which will remain exempt from the new tax measures, took a much lesser hit, falling around 2% on average. The table below presents the relative size of the different income trust segments of the Canadian stock market as at October 31, 2006:
It appears that individual investors were hit hardest by this market collapse, as institutional managers generally held a more conservative position in income trusts. Stock prices often considered high for income trusts, along with the uncertainty over their tax status, prompted several institutional managers to be especially cautious in the investments made in these securities. These managers could benefit greatly from the caution exercised as the underweighting of income trusts relative to the S&P/TSX Index should constitute a significant source of added value during the last quarter of the year.
Following the new measures announced by the Canadian government, managers do not appear to agree on what direction the income trust sector may take over the short and medium term. Some are predicting that stock prices will rise back up, while others are expecting them to plummet even further. In the past, several managers considered making income trusts a separate investment category. These tax changes may very well put into perspective how income trusts fit into management structures, especially since this form of business may be set to disappear over the next few years.
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