The recently announced increase in the dividend tax credit fails to create a level playing field between corporations and income trusts, according to a new report from the C.D. Howe Institute.

The report was prepared by Jack Mintz, President and CEO of the C.D. Howe Institute and Deloitte & Touche LLP Professor of Taxation at the Joseph L.
Rotman School of Management.

It concludes that the policy has largely failed to eliminate tax distortions. “The reason: businesses can increase their value by more than a third by converting corporate assets into income trusts,” it finds. “Further tax policy actions will be required if tax neutrality is to be established.”

The report says that by increasing the dividend tax credit, the minister has partially reduced the discriminatory taxation of dividends. “But investors who pay little or no personal tax on investment income remain unimpressed, because they obviously can’t take advantage of the tax break. This includes owners of pension funds, RRSPs and non-resident investors in Canadian equities,” it says. “The tax distortion remains.”

Tax-exempt investors comprise over 60% of the equity market, the report notes, and these investors prefer companies to convert business assets into income trusts since they can avoid paying corporate taxes at a 35% rate. As well, they pay no tax on income trust distributions, in the case of RRSP and pension plan owners, or a 15 % tax in the case of nonresidents.

“Getting lost in all this debate is another tax distortion that has not been addressed by the minister. While income trusts have achieved a lower cost of capital for business investments and better returns to investments by avoiding the discriminatory dividend taxes, there is one catch. The tax system encourages excessive distributions since trusts that retain taxable profits are subject to onerous taxation,” it points out.

“Undistributed income is subject to the top personal income tax rate where the trust resides (such as 39% in Alberta and over 46% in Ontario) and distributions from income earned in prior years is further taxed as capital gains in the hands of the unit holders. Thus, trusts have little choice but to make large distributions for tax reasons, which can be attractive to investors looking for high-yield investments but reduce the ability of businesses to fund investments with cheaper internal sources of capital,” it explains.

“When a corporation is converted into an income trust, investors will get a premium from the higher valuation of assets arising from reductions in tax, or so-called tax efficiency. Market value increases when the overall tax bill decreases,” the report concludes.

The conversion premium from a corporation shifting to income trust status virtually disappears for taxable investors (only 4.4% under the new regime in contrast to 22% under the old regime). However, for the majority of the market, the conversion premium remains at 58%, since pension plans, RRSP owners and non-residents can benefit from large tax efficiency gains with conversions to income trusts, it says.

“If the minister wishes to create a truly level playing field between corporations and trusts, he needs to carry out several other tax policies: make the dividend tax credit refundable to pension plans and RRSP owners so that they would be indifferent between corporation and trust assets; levy a corporate distribution tax to ensure that the refundable dividend tax is covered by corporate tax payments; increase the level of tax on non-residents receiving income trust distributions so that they pay a similar tax on corporate dividends and income trust distributions; reduce the tax penalty on income trusts so that they are indifferent with respect to paying out distributions or retaining income for tax reasons,” it counsels.

“None of these policies can be implemented overnight since they require a fundamental reform of the tax system,” the report finds. “However, it is better to take time to get things right than to rush into a decision. If income trust conversions remain unabated, hopefully the minister will politely create a truly level playing field next time when he needs to make sure the capital markets are operating efficiently.”