Tax Articles
No Halloween Treat for Income Trusts
CMA Management Magazine
George Vandebeek, CA
It seemed almost too good to be true… and it looks like it was.
On Halloween evening, October 31, Finance Minister Jim Flaherty delivered a “trick,” holding a surprise news conference to announce a new tax on income trust distributions. Stating that $70 billion of new trust conversions had been announced so far this year and that trust conversion was "a growing trend to corporate tax avoidance,” he introduced legislation to stem the rising number of companies converting to trusts.
Income trusts exploded in popularity chiefly because their structure allowed investors to be taxed directly on business income earned by the trust, giving trusts a tax advantage over such corporations as public and large private companies. The advantage arose because the combined corporate and personal tax on income earned in a corporation, which was taxed at general business rates and then paid out as a dividend to shareholders, was higher than the tax paid on income earned directly by an individual that was taxed only on a personal level, such as income received through an income trust.
Rather than attacking the income trust structure directly, the government introduced new rules for “eligible dividends” in the May 2006 federal budget. This meant that public company dividends would become subject to lower personal tax rates that effectively reduced or eliminated the tax inefficiency of using a corporation.
The introduction of these rules, however, did little to stem the growth of income trust conversions because it did not address the benefits of investing in income trusts enjoyed by both non-resident and tax-exempt investors. With recent announcements of further planned income trust conversions by several large Canadian public corporations, the government felt compelled to act.
From the government’s perspective, the main problem with income trusts was the growth of these investments held by tax-deferred plans such as RRSPs and pensions. With no corporate tax at the time the trust income is distributed, business income would not be taxed until the value of the tax-deferred plan was distributed in retirement, leaving the government with significantly less tax revenue. Income trusts held by non-residents also produced a loss of tax revenue.
The government’s intention is to make income trusts tax neutral when compared with corporations. The Finance Minister referred to “flow-through entities” (FTEs), indicating that these will be defined in the legislation once it is implemented. We can assume that the rules apply to any publicly-traded income trusts or publicly-traded partnerships, other than those that hold only passive real estate investments or portfolio investments.
- Real estate investment trusts (REITs) will not be subject to these new rules provided that the REIT:
- does not hold any non-portfolio properties other than real estate,
- earns passive income from the properties, at least 95% of which must be income from properties (i.e. dividends, interest, rents and taxable capital gains on real property) and at least 75% of which must be income derived from real property in Canada, and
- holds real properties in Canada, cash and debt or government debt that accounts for at least 75% of its equity value.
Income trusts will be subject to an income tax computed at the federal general corporate rate plus a proxy for provincial tax at 13%. This tax will apply on any distributed income from businesses carried on in Canada, income from non-portfolio investments in Canada and related capital gains. Distributions/income allocations of this income to trust unit holders will not be deductible in computing the tax base. For trusts, income that is not distributed in the current year will continue to be subject to tax at the highest marginal rates applicable to individuals. For partnerships, the new tax will apply to all such income, whether or not it is distributed.
For other passive earnings such as income and taxable capital gains from portfolio investments and for dividends received from Canadian corporations, the usual flow-through rules apply. For capital distributions, there is no change in tax treatment.
Recipients of payments from the income trusts will be taxed as though the payment is an eligible dividend under the new dividend taxation rules. Non-resident recipients of distributions will be subject to a 25% withholding tax, which may be reduced if the country in which they reside has an income tax treaty with Canada. Tax-exempt investors will not pay tax on distributions they receive.
There will continue to be an adjustment to the adjusted cost base of trust units to the extent that capital is returned as a tax-free payment.
The proposed rules will apply to all income trusts in 2007 that were not publicly-traded on or before October 31, 2006. All existing income trusts will be subject to these rules beginning with their 2011 taxation year.
The Finance Minister had no treats for existing income trusts. He indicated that more changes may come and warned that just because they are grandfathered until 2011, existing trusts should not assume the government will not attack any major expansions. He also warned that if the business community devises new structures or transactions that are clearly designed to frustrate this new policy, he may change any aspect of these measures accordingly.
Well, it did seem to be too good to be true, and it was. We’ll long remember Halloween night 2006, when income trust treats came to a crashing halt.
George Vandebeek is a partner of BDO Dunwoody LLP (www.bdo.ca). One of Canada’s leading accounting and advisory firms, BDO helps entrepreneurs and family businesses succeed. If you have questions about this article, or you would like a copy of BDO's Tax Factor newsletter, contact George in the Toronto north office at (905) 946-1066 or gvandebeek@bdo.ca.
