Letter from... Canada

Last October, Canada's Finance Department gave the business community a Halloween surprise that, for many, was more of a trick than a treat, writes Alison Arnot

Last October, Canada’s Finance Department gave the business community a Halloween surprise that, for many, was more of a trick than a treat. It announced a Tax Fairness Plan to ‘restore balance and fairness to the federal tax system by creating a level playing field between income trusts and corporations’. This plan included a tax on amounts distributed from income trusts and limited partnerships.

Income trusts had become an increasingly popular structure in recent years, with many of Canada’s top companies announcing their intentions to convert. The number of income trusts had grown significantly, from representing a market capitalisation of less than C$40bn in 2001 to more than C$200bn in 2006. Since income trusts and their investors enjoyed lower tax rates than large corporations and their shareholders, the Government saw this as a growing trend towards corporate tax avoidance.

The difference in tax treatment between corporations and income trusts or partnerships stems from the different roles these structures have historically played. Most large businesses, particularly public companies, have been organised as corporations. Partnerships have generally been smaller, owner-operated businesses, and trusts have served a variety of non-commercial and portfolio investment functions. Today, however, trusts and partnerships operate in many business sectors, and investments in them can be publicly traded. Thus, the role of the typical member or beneficiary has become essentially the same as that of a corporate shareholder.

Early in 2006, the Federal Government reduced the personal income tax rate payable on dividends of large corporations, equalising the tax treatment of a taxable Canadian investor’s income from trusts and corporations. However, the tax system still provided a bias in favour of investments in trusts for tax exempt investors, such as Canadian pensions and registered retirement savings plans, and for non-residents.

Under the tax plan announced in October, certain distributions of trust income will be subject to corporate tax rates and will not be deductible by the trust. Investors in the trust will be taxed as though the distributions were dividends.

Canada’s new tax applies as of 2007 to new entities, but is deferred until 2011 for trusts that were publicly traded as of 31 October 2006. The deferral was conditional, however, on the existing trust not undergoing ‘undue expansion’, but continuing at a normal growth rate.

In mid-December, the Finance Department provided the sector a small Christmas gift with its clarification of what ‘normal growth’ means. It would allow existing trusts to expand or merge with other existing trusts, as long as the expansion does not exceed the trust’s market value on 31 October 2006, or the merger, their combined market value. Essentially, the trusts could grow by 40% of the 31 October benchmark until the end of 2007, and then by 20% of the benchmark in each of the following three years – that is, by 100% before the transition period ends in 2011. In addition, trusts can convert back to a corporation without any tax consequences to investors.

Not surprisingly, reaction in the business world was divided. A November survey of 175 executives across the country, done by the Gandalf Group public opinion research firm, found 58% in support of the plan and 40% opposed. The heads of trusts were the angriest, with 82% saying they oppose the tax change. In contrast, 74% of the non-trust executives supported the move. The change in tax treatment has also resulted in uncertainty in the income trust sector; 42% of trust executives said they were set to reorganise out of an income trust, while another 42% said they no longer knew what business organisation best suited their company.

Alison Arnot is a freelance writer and editor, based in Ottawa.