Ottawa’s attempt to overhaul the tax treatment of dividends to stem the tide of corporate-sector conversions to income trusts is receiving mixed reviews from tax experts.

On the positive side, lowering taxes is always a welcome move. The general consensus, however, is that the draft legislation on dividend tax rules, released at the end of June, needs to be rewritten.

“Finance is overreaching with these rules. The rules are hopelessly complicated,” says Robin MacKnight, a tax partner with Wilson Vukelich LLP in Markham, Ont., and chairman of the technical committee for the Society of Trust and Estate Practitioners (Canada).

Second, MacKnight says, the driving force behind the proposed rules is to match the attractiveness of investing in public companies to investing in income trusts. Ottawa should revamp the rules so they apply only to public companies, he says.

As it stands, the draft legislation applies to both public and privately held Canadian companies.

The federal government expects its move will lower the combined federal/provincial top marginal tax rate on dividends from the current 24% to 37% to — depending on the taxpayer’s province of residence — as low as 14.6% on “eligible dividends.”

The change will be achieved by enhancing the combination of federal/provincial gross-ups and tax credits on eligible dividends. (See story, above, and page B4.)

The difficult part of this legislation is defining and tracking eligible dividends.

For Canadian-controlled private companies, these proposals are an added bonus to the favourable tax treatment that CCPCs already receive: CCPCs get a lower tax rate than other corporations on the first $300,000 they make each year; and investors get a special annual tax credit for the investments they put into CCPCs during the tax year.

As a counterbalance, any dividends that come out of that $300,000 will not be eligible for the new tax treatment. But income beyond that level is to be accumulated in a general rate income pool, representing the balance that will serve as a basis for issuing eligible dividends.

For publicly traded companies, eligible dividends could be paid out of net income — unless the company was a CCPC during the tax year and it had a low-rate income pool.

The new rules place responsibility for determining whether dividends are eligible on those companies that want to take advantage of the preferential tax treatment.

In short, companies have to keep track of their GRIPs and LRIPs.

Even more problematic, companies that designate dividends as eligible when they aren’t will be penalized. The Canada Revenue Agency will impose punitive taxes on the amount of dividends it determines to be ineligible.

The Investment Funds Institute of Canada and the Canadian Life and Health Insurance Association also have concerns.

For mutual funds to declare their dividends eligible, they have to know that the dividends they receive from other companies are also eligible, says Jamie Golombek, vice president of taxation and estate planning at AIM Funds Man-agement Inc. and chairman of IFIC’s tax issues committee. “They must be accepted by a company as eligible. But the company may not know,” he says.

Ron Sanderson, the CLHIA’s director of policyholder taxation, has a similar concern: “If I declare a dividend, I know how much I’m paying. But I may not know the source. It might not be as easy as Finance thinks to get source information.”

And, Sanderson adds, the amount of compliance involved in doing the necessary tracking will be costly. “It may not be worth the trouble,” he says.

As a result, says Golombek, the eligibility rule needs to be reversed. A mutual fund company should be able to assume all dividends it receives are eligible — unless the companies being invested in that issue dividends declare that they are not, Golombek says.

Recognizing that Ottawa may not want to give carte blanche agreement to this suggestion, IFIC also recommends that there be a minimum threshold.

For example, he says, as long as no more than 5% of dividends coming into a mutual fund are ineligible, then all of the dividends should be deemed eligible.

That would require an overhaul of the proposal, Golombek says: “That’s what we’re hoping for.”

The Investment Industry Association of Canada has its own unique concern about the new dividend tax treatment. IIAC president and CEO Ian Russell wrote to Finance Minister Jim Flaherty last month to draw attention to the adverse effects of the proposals on so-called “short sellers.”

@page_break@Russell says these market-makers need to buy shorted stock from actual owners, and part of any such agreement is that the short sellers compensate the lenders for any dividend paid out on the stock.

Under the proposed legislation, however, a compensation payment could not be considered an eligible dividend — prohibiting the lender from receiving the preferential tax treatment. The dividend compensation payment would not be a dividend paid by the issuer.

Therefore, says Russell, the IIAC is recommending that the proposed legislation be amended so such compensation payments would be treated as “eligible dividends.”

Time is getting tight, considering that this new tax treatment is supposed to apply to dividends paid out in 2006.

“The Finance Ministry needs to consider a quick solution for 2006,” Sanderson says. IE