Wednesday, November 01, 2006

Botched income trust policy hurt taxpayers, economy

VICTORIA - You can be angry at the Conservatives for breaking their promise not to plug the income trust tax loophole - especially if you lost money because you believed them.
But it’s a good move that will help average taxpayers and encourage a stronger Canadian economy.
And if you’re looking for the real bad guys in all this, turn your gaze to the former Liberal government, which chose to ignore the destructive effects of a flawed tax rules.
People tend to turn the page when they hit a column about tax policy. But this one is pretty straightforward, and important.
Corporations spotted a great tax loophole in income trusts about six years ago and proceeded to jump through it in ever-increasing numbers. The less they paid in taxes, the more the rest of us had to cough up. Eventually - way too late - the government decided to act.
It’s a simple enough proposition. Corporations pay taxes on their profits, including the money they send out to shareholders as dividends.
But their clever tax lawyers realized companies could avoid paying most of those taxes. All they had to do was create income trusts and register them. Profits paid to the trust, and then distributed to taxpayers, weren’t taxable. The company had more money left to hand out, so its value rose.
Nothing actually changed for the better in the business - it doesn’t make more widgets or improve in any way. But it was worth a lot more.
A few companies made the switch. The Liberal government did nothing. So more jumped at the chance to cut taxes and boost their value.
The Conservatives promised they would leave the loophole open, so some of Canada’s biggest companies decided to become income trusts. The trickle of trust conversions became a wave. One estimate put the net lost revenue to government - recognizing that individuals would pay taxes on their gains - at $1.1 billion a year and growing.
So Finance Minister Jim Flaherty delivered his Halloween scare for investors. The tax loophole is closed immediately for companies that haven’t converted, bad news for corporations like Telus that were expected to make the change. Its share price fell 13 per cent on the first day after the announcement. Companies that have already made the shift will keep the tax break until 2011. Their values fell too.
Flaherty did the right thing.
It isn’t just that the corporate efforts to avoid taxes shifted the burden on to the rest of us. Regular corporations can take a look at their financial statements and decide what to with profits - pay dividends, reduce debt or invest in new technology or expansion. But income trusts commit to sending a fixed amount to unit holders each year. There’s a risk that investment in the future suffers.
The big lesson here is that government dithering can be expensive.
The income trust issue didn’t catch government by surprise. Australia and the U.S. went through similar experiences almost two decades ago and decided to close the tax loopholes.
And six years ago, as companies started looking at the income trust option, Canada could have taken the same step with little negative impact.
The Liberal government didn’t. Big corporations liked the chance to pay less tax. With each passing month of government inaction, more people had a stake in the trusts and would be angry at any change. The Liberals and the Conservatives let it slide, until now.
Investors aren’t the only losers as a result. Companies spent hundreds of millions of dollars converting to income trusts and developing new business plans. They developed new long-range business plans.
And then government changed the rules and made their investment worthless.
It’s a sorry tale. A responsible, effective government would have never let the whole trust spree get this far. The result has been lost government revenue, scary times for some investors and wasted time and money in the corporate sector.
Footnote: Trusts, with their regular payment schedules, were popular with seniors. The change hurt them. Flaherty offered an offsetting benefit. Couples can now split one person’s pension income for tax purposes, shifting them into a lower tax bracket. The change will be most significant for those with a high pension income.

9 comments:

The Commentator said...

Canada. Responsible? Surely you jest. Well put. However, I feel that the notion that companies would rush to convert to income trusts was slightly over done. The problem is that many seniors had increased their IT holdings to increase their payouts. It's ironic that Conservatives did this. Then again, aren't the Conservatives the ones who introduced many of Canada's socialist treasures?

World of Warcraft Gold said...
This comment has been removed by a blog administrator.
Anonymous said...

Legal or ethical, that is/was the question. Greed can be a wonderful motivator, but unfortunately it rarely proves to be a productive one. Investment trusts were nothing more than legal flimflam.
Companies and investors who have lost because of the closure of what every informed investor new to be a loophole which simply shifted a burden to others deserves what they got, it's as simple as that.

Anonymous said...

"Flaherty offered an offsetting benefit. Couples can now split one person’s pension income for tax purposes, shifting them into a lower tax bracket."

I wonder how the income tax people will define "couple" if Harper gets a majority government?

Anonymous said...

The income trust issue was even worse than you describe: in converting to an income trust, these corporations committed to ensuring a regular payout of income to the holders. This would've led to a change in focus from long-term capital investment to short-term management intended to distribute cash, and that wouldn't have done anything good for the competitiveness of these companies. Corporations are major employers and major generators of wealth in Canada, so we've got to make sure that they stay healthy.

Anonymous said...

2.02 brings up a intersting point about "couples" with any luck at all, we will never find out as steve and his freinds should be gone before very long adnd while the country is pretty well in one piece. Two people who love each other, regardless of the sex of either is their business not the buslienssw of a bunch of right wingers. we all know folks who are gay, heck a lot of celebrate the fact. Let's not casue any more trouble for these folks.

deaner said...

"This would've led to a change in focus from long-term capital investment to short-term management intended to distribute cash, and that wouldn't have done anything good for the competitiveness of these companies."
Yeah: it worked so well to ensure that Magna Entertainment, Nortel, Royal Group, and BCE remained productive and competitive - it sure is a good thing they weren't Income Trusts or they might've been real train wrecks!

"Corporations are major employers and major generators of wealth in Canada, so we've got to make sure that they stay healthy."
So we'll try anything, save a reduction in taxes across the board that would reduce the relative advantage of the trust structure, allow better accumulation of capital, and reduce the relative benefit of tax-reduction strategies compared to operational-improvement strategies. If we get desperate enough perhaps, and if people stop believing that "corporations" (as distinct from their shareholders, employees, suppliers, or customers) actually pay taxes. I'm not holding my breath.

wstander said...

This is a pretty one side, and even naive view of the issues. For one, more sophisticated look, seehere.

http://www.theglobeandmail.com/servlet/story/RTGAM.20061104.wxr-cover04/BNStory/Business/home

Anonymous said...

Thanks for the link wstander.

My favourite line?
"I've never seen anything like this in my life, what they can do,” he [David Cynamon, Chief Executive Officer, KCP Income Fund] said of the government's decision. “If this happened in the regular business world, you'd be sued, you'd be arrested."

Pretty much what the union's were saying when Gordo's BC Liberals were ripping up collective agreements - business leaders were silent at that time... now they are howling mad when the same happens to them.