Sure, the federal government botched its income trust consultation. But at least it put the controversy to bed sooner than expected. Or did it? While the feds have made their decision, it is up to the provinces to make corresponding changes if there is to be any real change.

In late November, the feds cut short a public consultation on how to eliminate the tax advantage enjoyed by income trusts, and instead tinkered with the taxation of corporate dividends.

Effectively, the feds proposed to cut taxes paid on dividends by increasing the “gross up” applied to dividends and providing a larger dividend tax credit. The goal is to eliminate the double taxation of dividends. In turn, that would make the income trust structure less attractive to companies than the traditional corporate structure.

Critics of the measure point out, however, that the government’s proposal falls short of the objective for a few reasons. For one, tax-exempt investors (such as RRSP owners and pension plans) and foreign investors will still pay less tax under the trust structure than the corporate structure, even with the tax cut, which preserves the incentive for companies to convert to the trust model.

Even for taxable investors, the government’s move doesn’t make the tax system neutral — unless provincial authorities implement their own dividend tax cuts. So far, none have committed to doing so.

Provincial cuts are crucial for companies that are contemplating converting to the trust structure. For example, Toronto-based CI Financial Inc. has long mused about the possibility of converting to a trust. Indeed, it had decided to do so when the federal government started hinting that it would probably slap a tax on trusts to remove their tax advantage, and halted the advance tax rulings that some companies seek before converting.

Once Ottawa decided to go ahead with the dividend tax cut, it was assumed that companies such as CI would be less eager to convert. But, as CI CEO Bill Holland explained in the company’s second-quarter conference call on Jan. 10, the decision isn’t that easy without some clarity from the provinces on how they intend to treat dividends.

“Our intention is to significantly increase the distribution ratio of our earnings. But we have to wait and see what the tax rate on dividends will be,” says Holland. “We really don’t have any idea. The Ontario government has said nothing.”

Holland notes that one way or another, CI intends to pay out almost all its earnings. The question is whether it does so via dividends, or as a trust distribution. And that decision depends on the respective tax rates. “All we’re looking for is some certainty,” Holland says, adding that when news of the proposed dividend tax cut first came down, it appeared as if a trust conversion would not be necessary. CI has since decided that without perfect clarity as to the two structures’ respective tax treatments, it’s too soon to make a judgment.

The provinces have been mostly mum on the issue. They are unlikely to start making such decisions in the midst of a federal election campaign, which creates its own uncertainty about just what the federal position on the issue will be after Jan. 23.

The federal Conservatives have promised to preserve the Liberal’s dividend tax-cut approach to dealing with the income trust issue. So, it appears the cut will remain —regardless of the election’s outcome.

Quebec Finance Minister Michel Audet is the only provincial minister with much of anything to say on the matter. In mid-December, he said: “Quebec’s tax legislation will not be amended since the Quebec tax system that applies to dividends does not lead, for Quebec taxpayers, to double taxation at the provincial level.” The technical details of the federal proposal remain unknown, he said.

Holland says a new federal budget may be required before the provinces decide where they stand on the issue. In fact, many provinces are in the midst of their own budget development process right now.

British Columbia has yet to decide what to do about dividend taxation, says Robert Pauliszyn, communications director in the B.C. Ministry of Finance. “In light of the federal proposal, the minister of finance is currently considering whether or not to change B.C.’s dividend tax credit mechanism as she prepares the 2006 provincial budget,” he says.

@page_break@The B.C. budget will be handed down Feb. 21. In the meantime, there are no hints as to the province’s probable direction.

It is much the same story in Saskatchewan. Lorri Thacyk, manager of public relations in the Finance Department, indicates that Saskatchewan’s next budget (due this spring) is probably the earliest that it will address the issue. “The federal decision to change the tax treatment of dividends was made without any prior consultation with the provinces. The federal announcement came as a complete surprise,” Thacyk says. “Provinces need time to consider the implications of the federal changes on provincial taxes and provincial taxpayers, on interprovincial capital flows and on income trusts.”

New Brunswick’s Finance Department says its next budget, slated for March 28, will include any change it intends to make to its dividend taxation policy.

Nova Scotia’s Finance Ministry says the issue is under consideration there, too, but no decision has been made. Such tax policy changes would usually come in the province’s spring budget, notes Cathy Shaw, director of communications for the Nova Scotia ministry.

The next budget may even be too soon for some provinces to think through all the implications. Tracy Balash, communications director in Alberta’s Finance Ministry, says the government is still reviewing the issue and has set no deadline for making a decision. Balash adds that it’s unlikely the issue will be dealt with in its upcoming budget, due in March. “We’re well into the budget cycle and it is doubtful this will be addressed in the next budget,” Balash says.

For the provinces, there may be questions about whether such a tax cut is fundamentally affordable, whether it’s fair and how it impacts capital flows. Although the federal government may have decided it can absorb a dividend tax cut, the issue may not be as easy for provinces struggling with deficits. In the last round of provincial budgeting, only Alberta, Manitoba, New Brunswick and Newfoundland were in surplus. The other provinces are working to cut deficits, and tax cuts for investors may not be in their plans. The heftiest deficits are in Ontario, Quebec and B.C.

Ontario may be one province in which matching the federal move is a bit of a strain, given its large investor population and deficit position, says Jack Mintz, president and CEO of the Toronto-based C.D. Howe Institute. He says provinces with relatively small corporate tax bases relative to personal bases, “might not like giving up credits for other provinces.” Still, he expects that most provinces will ultimately go along with the federal plan.

For its part, Ontario indicates that it will wait and see just what Ottawa implements before it decides what to do at the provincial level. “We understand that the federal government will need to introduce legislation to implement this change. Ontario will review the federal proposal and consider its options,” says Manuel Alas-Sevillano, spokesman for Ontario’s Ministry of Finance.

Ontario’s new finance minister is in the midst of his own pre-budget consultations. Alas-Sevillano says, however, that it is “much too early in the process to know what will be addressed in the budget.”

Nevertheless, Don Drummond, chief economist at TD Bank Financial Group in Toronto, says affordability won’t be the key factor for provinces deciding how to respond to the federal move. B.C. and Newfoundland have both cut taxes while in deficit, he points out.

“I would hope all provinces increase their dividend tax credit,” Drummond adds. “Remember that if they don’t do anything, provincial taxation on dividends will go up because provincial taxation comes after the gross-up [which the feds will increase].”

Still, until the provinces bring down budgets and announce their responses to the federal initiative, companies considering trust conversion are left plagued by uncertainty. IE