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The Canadian Experience with Income Trusts

The Canadian Experience with Income Trusts. Outline. What are income trusts? Tax policy implications Experience in selected countries Revenue implications and economic efficiency issues Recent developments Questions. Collective Investment Vehicles in Canada.

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The Canadian Experience with Income Trusts

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  1. The Canadian Experience with Income Trusts

  2. Outline • What are income trusts? • Tax policy implications • Experience in selected countries • Revenue implications and economic efficiency issues • Recent developments • Questions

  3. Collective Investment Vehicles in Canada • Trusts widely used as a collective investment vehicle in Canada • Mutual funds are generally established as trusts • Mutual funds hold portfolio of public stocks and bonds

  4. What are Income Trusts? • Trusts governed by provincial laws • Ownership vehicle for a business • Ownership of a single company rather than shares of a portfolio of companies • designed to eliminate corporate income tax on the underlying business • Raise funds by selling units in the trust to public investors.

  5. REIT • Trust has a leasehold interest in properties held by the operating corporation • Trust receives lease income • Lease payments are deductible by the operating corporation

  6. Energy (Royalty ) Trust • Trust has a royalty interest in properties held by the operating corporation • Trust receives royalty payment • Royalty payments are deductible by the operating corporation

  7. Business Income Trust (First Generation) • Trust owns an operating corporation • Operating corporation issues subordinated debt to trust • Operating corporation pays interest to the trust and does not pay corporate tax

  8. Business Income Trust (Second Generation) • Operating corporation replaced by limited partnership (because of flow-through nature of partnership) • Operating trust sits in between limited partnership and income trust to avoid foreign property limit applying to Canadian pension plans (public and private)

  9. Business Income Trust(Third Generation) • Foreign property limit repealed in the 2005 budget • Operating trust not required

  10. Recent Growth • Energy trusts and REITs since mid 1980s • Business income trusts are more recent. • Market capitalization was $193 b at end of 2005 (11% of S&P/TSX); up from $18 b in 2000. • Could continue growing (listing on S&P/TSX and provincial limited liability laws)

  11. Types of Income Trusts

  12. Tax Policy Implications • Income trusts deduct distributions to investors (unit holders) in calculating taxable income of the trust • Trust pays income tax (top personal rate) on taxable income • Taxes paid depend on investor (Canadian retail, tax-exempt (e.g., pension funds), non-residents • Corporations pay corporate income tax and shareholders pay tax on dividends • Cases of over and under integration in Canada

  13. Experience in Selected Countries • U.S. generally treats flow-through entities as corporations • exceptions include REITs and certain partnerships • Since the mid-1980s, Australia has taxed certain publicly listed vehicles as corporations • However, Australian tax system fully integrates the personal and corporate tax systems. • The U.K. recently announced a tax regime for REITs

  14. Tax Revenue Implications • Estimated impact on federal tax revenues was $300 m in 2004 (approximately 1% of federal corporate tax revenues) • Business trusts accounted for $120 m • Estimate compares income tax under the corporate structure and income trust structure • Estimate sensitive to certain parameters (e.g. tax-exempts) • Provincial government implications as well • Estimate for 2005 is higher (60% growth since 2004)

  15. Economic Efficiency Issues • Some have said that income trusts lead to greater economic efficiency • Others have said that the tax system may reduce economic efficiency by distorting investment decisions

  16. Recent Developments • Canada recently carried out consultations on income trusts (and limited partnerships) • Important public policy issue in Canada • Views on both sides of the issue • Some see income trusts as positive development and low risk to government revenues • Others see potential risk to economic growth, investment, productivity and tax revenues

  17. Issues • Issues that were raised as part of the consultations were: • impact of their tax treatment on how businesses are organized in Canada • economic growth, investment and productivity • impact on government tax revenues • potential role tax-exempt investors may have in this market

  18. Government Response • Better integration of the personal and corporate income tax systems • Increase the dividend tax credit for dividends from large corporations to fully compensate investors for underlying corporate income tax • Takes into account recent proposals to reduce corporate income tax

  19. Questions • What is the experience in other countries? • What actions are being/have been taken? • Views on integration? • Views on pressures on the debt/equity borderline?

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