In a last-second move for the minority government, federal Finance Minister Ralph Goodale put an end to his ill-conceived consultation on income trusts by coming up with the best solution for which investors could have hoped: a dividend tax cut. The decision doesn’t solve the policy problem Goodale was worried about, but it is welcome nonetheless.

After the markets closed Nov. 23, Goodale announced he was ending his income trust consultation more than a month early and moving to cut taxes on dividends. The change is designed to ameliorate the tax arbitrage between the trust structure and the traditional corporate structure.

The consultation came abruptly to an end when it became clear the Opposition parties in Ottawa were intent on defeating the minority Liberal government and forcing a winter election.

After announcing the decision, Goodale told reporters he would have preferred to let the full consultation process run its course. “But weighing that against the volatility and the uncertainty that might flow during an election campaign,” he said, “I decided that it was in the public interest to bring this to a definitive conclusion now.”

The move is meant to make companies more or less indifferent as to whether they structure themselves as income trusts or corporations. Under the old regime, the trust structure provided clear tax advantages, as virtually all a company’s income could be flowed through to unitholders and taxed only in their hands, not at the corporate level. The result is that trusts faced a lower cost of capital than similar firms organized as corporations.

The disparity had existed for some time, but the government seemingly became worried about it only when a slew of large mainstream companies began to announce plans to convert to the trust structure. CI Fund Management Inc. and Precision Drilling Corp. said they would convert in September and, most troubling for the government, Royal Bank of Canada CEO Gord Nixon mused publicly about the possibility of spinning off some of the bank’s businesses into trusts.

Corporate comfort with the trust structure has grown in the past few years as some of its weaknesses disappeared. Provincial governments introduced legislation limiting liability for trust unitholders, closing a legal loophole that had kept many institutional investors away from the product. And trusts are also in the process of being added to the primary Canadian equity index. These developments, along with a prolonged period of low interest rates that has stoked investor demand for the high-yield products, helped persuade traditional firms to take the plunge.

The government had indicated that the resulting flood of trust conversions worried it for two reasons. There was the direct possibility of lost tax revenue. The second concern was that the capital cost advantage would distort the economy by favouring the sort of slower-growth firms that work best in the trust structure, and hamper growth-oriented companies that can’t afford to pay out all their profits because they need to reinvest in their businesses.

Although the government’s concerns may be valid, the way it had approached the issue certainly spooked investors. The initial market reaction to the announced consultation process was indifference. The government then upped the ante by declaring a moratorium on advance tax rulings for companies contemplating conversion to the trust structure. The move didn’t necessarily halt conversions, but it certainly made it tougher for cautious corporate boards to consider the idea.

CI abandoned its conversion plans upon hearing the moratorium announcement, while Precision Drilling decided to plow ahead, as did brokerage firm GMP Capital Corp. (On Nov. 25, GMP announced that it had received final court approval for its proposed conversion into GMP Capital Trust. It expected the move to take effect Dec. 1.)

Upon cutting short the consultation and announcing the dividend tax cut, Goodale said that the Canada Revenue Agency would resume giving advance tax rulings. He also immediately tabled a Notice of Ways and Means motion to implement the cut, which takes the form of an enhanced gross-up and an accompanying tax credit. Eligible dividends will be grossed up to 45% (vs the current 25%) so that shareholders will now report 145% of the dividend amount as income. The dividend tax credit will be 19% (up from 13.3%). Eligible dividends will generally include those paid after 2005 by Canadian publicly traded companies.

@page_break@“Reducing the taxes individuals pay on dividends will encourage savings and investment and will help establish a better balance between the tax treatment of large corporations and that of income trusts,” Goodale said. “This action will benefit Canadians and result in bottom-line tax savings for them.”

The government estimates that the additional dividend tax relief will cost it about $300 million in annual revenue. That was also its estimate of the amount it lost in so-called “tax leakage,” caused by companies arbitraging the tax system by converting to the trust structure.

The decision to implement a dividend tax cut instead of changing the tax regime for income trusts was roundly praised from almost all corners of the financial industry. “This is a very positive development and represents arguably the best of all possible outcomes,” notes TD Bank Financial Group in a report. It says the government’s proposed solution doesn’t disrupt the trust sector, provides some tax relief, reduces the double taxation of dividends and increases the incentive to save and invest.

Perhaps the clearest indicator of the market response to the decision was the 162-point rally the S&P/

TSX composite index enjoyed the day after the announcement. It subsequently pulled back a bit, but the rally in existing trusts, prospective trust converts (such as CI) and traditional dividend-paying stocks such as the large banks all reflect investor approval of the decision. Investment bankers and advisors that have made their living on the back of the income trust boom in the past few years were also understandably chuffed at the news.

In response, BMO Nesbitt Burns Inc. has upgraded both CI and TSX Group Inc. “TSX stands to benefit from increased business activity as well as valuation,” it says, noting that CI now has options for paying out its free cash flow to shareholders in a more tax-efficient way. “We also expect that CI’s valuation is more sustainable, given this development, and is likely to position it with a stronger acquisition currency.” The report also suggests insurers Manulife Financial Corp. and Sun Life Financial Inc. could raise their dividends.

Notwithstanding

the market’s joy, there is some fear that while a dividend tax credit is certainly welcome, and it does create better balance between the trust and corporate structures, it doesn’t fully resolve the disparity. For that to happen, TD notes, the federal government must follow through on promised corporate tax cuts, and the provinces must imitate the new federal treatment of dividends.

Also, as TD and others have pointed out, even under the new system, tax-exempt investors (RRSPs and pension plans) and foreign investors will probably still favour income trusts. Tax-exempt investors will continue to prefer trust distributions to corporate dividends because the dividends will have been taxed at the corporate level, whereas the trust income can be flowed through tax-free. As well, foreign investors pay just 15% in taxes on trust distributions, which is still meaningfully lower than what they’ll pay on dividends.

Although there are plenty of arguments to be made about whether government revenue ultimately suffers from this — some maintain that the revenue is merely deferred rather than lost forever — there is still a powerful incentive for companies to consider the trust structure. So, if large conversions continue to occur after this decision, there’s always the risk that future governments could revisit the issue.

There’s also some risk that the tax cut may not be implemented, given the political uncertainty in Ottawa. However, Goodale indicated in his press conference that once the motion is before the House of Commons, the CRA will generally treat it as if it were the law of the land. It seems unlikely that either of the top two parties in the polls, the Liberals and the Conservatives, would back away from the decision.

Whatever happens on the tax front, the trust sector is also facing strong criticism from independent analyst and forensic accountant Al Rosen, head of Toronto’s Accountability Research Corp. Prior to Finance’s decision, his firm had issued a report saying the business trust segment of the income trust market could be overvalued by as much as 28%. In the report, Rosen argues that 75% of the 50 largest business trusts are paying distributions that are well in excess of their net income — a situation he says is not sustainable in the long run.

Rosen says the boom in trust conversions is not primarily a tax arbitrage move; rather, it’s motivated by companies seeking the excessive valuations that trusts seem to enjoy. The reason he believes they’re overvalued is that many investors don’t understand that some portion of trust distributions includes a return of their own capital, and so they are overestimating the income-generating ability of trusts compared with traditional corporations. Moreover, he suggests that trusts are significantly underestimating the future capital spending needed to maintain their capital assets.

He recommends a 10% tax on business trusts, along with a dividend tax credit. He also calls on authorities to crack down on the “accounting, valuation and marketing abuses surrounding business trusts.”

Income trusts got off lightly this time, but they may yet be facing a day of reckoning. IE