Government Deals with Income Trusts
November 2006
Release No: 06-05
Introduction
On the evening of October 31, 2006, the Finance Minister held a surprise news conference to announce several new tax changes that will have a significant impact on publicly-traded income trusts and partnerships. The proposed changes with respect to income trusts came as a shock and created uncertainty in the financial markets as these changes could very likely eliminate any further interest in income trusts. Two of the tax proposals appear designed in order to soften the impact of the income trust changes for seniors, who have been major investors in these structures.
In recent years, the income trust structure has become very popular with both the business and investment communities. One of the main reasons for its popularity is the income trust structure effectively allowed investors to be taxed directly on business income earned by the trust, giving these trusts a tax advantage over certain businesses carried on in a corporation, such as a public or large private company. This was due to the fact that the combined corporate and personal tax on income, earned in a corporation and subject to tax at general business rates and then paid out as a dividend to shareholders, was higher than the tax paid on income earned by an individual directly 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 in the May 2006 federal budget for “eligible dividends”. Generally, public company dividends will become subject to lower personal tax rates that effectively reduce or eliminate the tax inefficiency of using a corporation. Refer to our publication Fast Fact 06-04 Taxation of Dividends – The New Rules for a summary of the new rules for the taxation of dividends.
The introduction of the new rules for eligible dividends, however, did not have a large impact on stemming the growth of income trust conversions due to the fact that it did not address the benefits of investing in income trusts that were enjoyed by both non-resident and tax-exempt investors. Due to the recent announcements of further planned income trust conversions by a number of large Canadian public corporations, the government felt compelled to act.
We will first review the other tax changes announced by the government before turning our attention to the proposed changes to the taxation of income trusts.
Reduction to the General Corporate Tax Rate
In addition to the corporate tax cuts previously legislated, the Finance Minister announced a further reduction to the general corporate tax rate by 0.5% effective January 1, 2011 to bring the rate down from 19% to 18.5%. The rate will be prorated for corporations with non-calendar taxation years. The chart below summarizes the federal corporate tax rates to 2011:
| |
2006/07 |
2008 |
2009 |
2010 |
2011 |
| General corporate rate |
22.12% |
20.5% |
20.0% |
19.0% |
18.5% |
New Income Splitting for Seniors
To lessen the impact of the income trust proposals, beginning in 2007 Canadian resident seniors will be able to split pension income with a spouse or partner if they so choose. They will be able to allocate up to 50% of their eligible pension income received to their partner on a discretionary basis. As the income will still be paid to the individual that has the pension entitlement, this allocation will require both partners to jointly elect to have the income “reallocated” on an annual basis. Despite the reference to seniors, no direct age test was proposed as part of this change. The ability to split income will be based on existing pension rules, which have one set of rules that apply to those 65 or over and more restrictive rules for those under 65.
Increase to Age Credit Amount
Also in an attempt to mitigate the impact of the income trust proposals, the age credit amount, which can be claimed by taxpayers who are 65 or older, will increase by $1,000 to $5,066 effective January 1, 2006. Note, however, that the age credit begins to be phased-out when net income reaches $30,270. With the proposed change, the age credit will now be fully phased-out when net income reaches $64,043. Therefore, this proposed change will not provide any benefit for those individuals who are subject to the full clawback of the age credit amount.
The Income Trust Proposals
As discussed in the introduction, the government has major concerns regarding the current income trust structure. From the government’s perspective, the main problem with income trusts was the growth of income trust investments held by tax deferred plans such as RRSPs and pensions (previous research by the Department of Finance showed that a large portion of recent income trust growth was due to units held by tax-exempt investors). 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. As well, income trusts held by non-residents also produced a loss of tax revenue.
Finance had several foreign models to study. The U.K. had basically banned such publicly-traded entities while the U.S. and Australia had introduced tax changes to remove any tax advantage. The intention in Canada is to make income trusts tax neutral when compared with corporations.
In a nutshell, if a trust or partnership is subject to the proposed changes (referred to by Finance as a flow-through entity or FTE), the FTE will be treated in a similar manner to a corporation and investors will be taxed as shareholders.
What sort of FTEs will be caught?
The Finance Minister made it clear in his announcement that FTEs who will be subject to the new rules will be fully defined in the legislation once implemented but that as a practical matter, it can be assumed that the rules apply to any publicly-traded income trusts or publicly-traded partnerships, other than one that only holds passive real estate investments or holds only portfolio investments. For simplicity, in the remainder of the Fast Fact, we will refer to the FTEs that will be subject to these new rules as “income trusts”.
Will these rules apply to REITs?
Real estate investment trusts or 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 which 95% must be income from properties (i.e. dividends, interest, rents and taxable capital gains on real property) and at least 75% 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.
How will the new tax regime work?
In very general terms, income trusts will be subject to an income tax that will be 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 by it in Canada, income from non-portfolio investments in Canada and related capital gains. Distributions/income allocations of this income to trust unitholders 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 income described above whether or not 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 will be available. For capital distributions, there will be no change in tax treatment.
It is proposed that this new tax will be applied and collected at the federal level only and that the federal government will then distribute the tax to the provinces. This allocation process will have to be negotiated with the provinces.
How will recipients be taxed?
Recipients of income payments from the income trusts will be taxed as though the income 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 by an income tax treaty Canada has with the country where the non-resident lives. 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.
When will the rules take effect?
The proposed rules will apply to all income trusts in 2007 that were not publicly-traded on or before October 31, 2006. Therefore, the proposed Bell Canada and Telus income trusts will be caught, and based on the distribution tax rates discussed above, it is likely these conversions will be abandoned. All existing income trusts will be subject to these rules beginning with their 2011 taxation year.
Are there more changes to come?
The Finance Minister has indicated that more changes may come and gave a specific warning to existing income trusts that just because they are grandfathered until 2011, they should not assume that Finance will not attack any major expansions to existing income trusts. In addition, the government warned that if there should emerge structures or transactions that are clearly devised to frustrate the new policy of the government, any aspect of these measures may be changed accordingly and with immediate effect
For more information on how these rules will affect you, contact your BDO advisor.
Please note: this material is general in nature and should not be relied upon
to replace the requirement for specific professional advice. © November 2006, BDO Dunwoody LLP
