The federal govern-ment offers both a financial and an ideological rationale for its proposal to alter the way in which income trusts are taxed, but parliamentary hearings show neither is entirely convincing.

The House of Commons standing committee on finance held hearings Jan. 30 and Feb. 1 to listen to all sides of the income trust issue, including Finance Minister Jim Flaherty, the pro-trust lobby and various industry analysts. The hearings cast some doubt on the feds’ reasons for changing the taxation of trusts.

Ottawa says its motivation is two-pronged. It is worried about missing out on tax revenue because companies can now avoid taxes by structuring themselves as trusts. And it believes trusts have a tax advantage over traditional corporations. It worries that the proliferation of the trust structure could undermine the economy by causing companies to underinvest in themselves so they can maintain their distributions to unitholders.

Flaherty told the committee the tax loss from trusts in 2006 was $500 million for federal coffers and $760 million for provincial treasuries. The numbers did not include the possible trust conversions of telecom giants BCE Inc. and Telus Inc.

Given such large potential revenue losses, and more if other firms choose to convert, the government had to act, Flaherty said. For this reason, he is resisting calls to extend the transition period, saying pushing the deadline to 2017 from 2011 would cost Ottawa another $3 billion, and billions of dollars more in lost provincial revenue.

Estimates of federal revenue loss are conservative, he said, stressing that calculations are based on the methodology used by the previous Liberal government in the first consultation paper on the issue.

The policy’s critics say the government fails to account for the fact that a substantial number of trust units are held in tax-deferred accounts. The government estimates 38.5% of units are controlled by such investors; critics say the revenue will be captured later, when investors draw on their retirement savings.

Yves Fortin, a retired Finance Department economist, argued tax revenue in the long run will be higher than it otherwise would have been because most trusts yield 8%-10% annually — well ahead of inflation, now about 2%.

Anticipating this argument, Flaherty told the committee: “I have a fiduciary obligation to the taxpayers of today, not tomorrow. I have an obligation to pay for needed social, environmental and economic programs today, not tomorrow. I cannot and will not fund today’s programs from tomorrow’s revenue.”

Other witnesses gave more reasons why the federal government may be overestimating the tax leakage from trust conversions.

Gordon Tait, managing director and research analyst with Bank of Montreal, argued that the government captures more taxes when companies are organized as trusts than as corporations.

BMO studied 126 companies that converted to trusts between 2001 and 2005, comparing the taxes each paid as a corporation with taxes collected in the first year as a trust. Using Finance’s methodology, BMO found that, on average, the government collected 1.5 times as much taxes from the trust as it did from the corporation. For royalty trusts, the average was four times as much.

The reason government may collect more taxes from trusts, Tait explained, is because companies pay out more of their income to unitholders than they would via dividends if they were structured as traditional corporations. As a result, a larger portion of their cash flow is taxed in the hands of individuals. Because personal rates are higher than corporate rates, and individuals have fewer ways of minimizing their tax bills than corporations do, trusts generate more taxes overall in practice than the theory might predict.

Other arguments came from HDR|HLB Decision Economics Inc. The firm’s vice president, Dennis Bruce, said real federal tax leakage in 2006 was $164 million, not $500 million.

Of the $336-million difference, he said, $80 million comes from the value of deferred taxes, which Flaherty said he hadn’t considered.

Bruce said the government overestimates the proportion of trusts held by tax-deferred investors, arguing it is about 31% rather than 38%. This would lower the leakage estimate by $125 million, he said.

The government’s own sensitivity analysis shows if tax-deferred investors held only 25% of the trusts, the leakage estimate would be cut in half to just $225 million. Conversely, if 50% of the trusts were held by tax-deferred investors, the estimate would rise to $705 million.

@page_break@Falling corporate tax rates is another reason cited for the difference between the estimates of HDR|HLB and Ottawa. Critics say Finance’s estimate fails to account for tax rate reductions for resources firms from 2004 to 2006, which means the government overstates the leakage by $84 million a year. HDR|HLB also claims legislated corporate tax reductions over the next three years will reduce the leakage by $232 million a year. As a result, the annual leakage would only be about $32 million a year after 2010.

But, even if Ottawa concedes the tax leakage dispute, which it doesn’t, its trump card is that the current system is simply unfair and distorting, because it treats one type of business structure differently than another. There shouldn’t be starkly different tax regimes for different business structures.

While fairness and neutrality appear to be uncontested ideals for a tax system, it is not that simple.

For one thing, the government’s proposal won’t eliminate different tax treatments for different businesses. Notably, REITs that meet certain conditions will be exempted from the new method of taxation, largely because other countries have done so. And the new regime would only apply to publicly traded trusts, so investors who can afford to participate in private trusts will continue to enjoy a tax advantage.

The discrepancies show that it’s easy to talk about “tax fairness,” yet it’s not clear what this really means or whether it can be achieved.

Tax codes are extremely complex and open to exploitation by shrewd accountants, whom only wealthy individuals and corporations can afford. Moreover, if the government is concerned about fairness, it should scrap all consumption taxes and introduce a single rate for income taxes. Consumption taxes fall disproportionately on the poor, whereas income taxes are levied at different rates according to income. But governments have many competing priorities that prevent the adoption of fair, straightforward tax codes.

Although there shouldn’t be a significant tax advantage to structuring a business as a trust or a corporation, the plan to change the way trusts are taxed creates disparities. It is difficult to buy the fairness argument without the tax leakage, and the magnitude of leakage is an open question.

It’s unlikely much will come from the hearings, as the government has shown no indication of backing down from its decision or modifying it by extending the transition period. Nor is it likely the Opposition would force an election on the issue.

Ottawa also has the support of the provinces. Flaherty presented letters from most of his provincial counterparts confirming their endorsement of the decision. Bank of Canada Governor David Dodge also suggested at the hearings that he is generally in favour of the move to make the tax system neutral between trusts and corporations.

Many analysts expect the policy will be implemented much as conceived.

“The finance minister seems resolute in his position,” Genuity Capital Markets says in a report. “We seriously doubt rebuttal of the methodology to calculate tax leakage, dollar value, merits of including future revenue streams or extending the transition period will alter the legislation.” IE