The federal government has identified three broad choices to deal with the perfect storm it has created through its handling of the income trust file.

But the route that appeals to many experts — full integration of the corporate and individual tax systems — is also the one that is most unlikely to occur quickly, given its estimated cost of $2 billion, not to mention the government’s shaky political standing.
The other two options laid out in the fed’s consultation paper on income trusts— limiting the deductibility of interest expenses and taxing flow-through entities the same as corporations — have more than their share of critics.

Recall that Ottawa, concerned about tax leakage and musings from some big financial companies about adopting an income trust structure, slammed the brakes on the booming income trust market by halting advance tax rulings in late September. That shocker came a couple of weeks after the feds released a consultation paper in early September that outlined possible policy changes. The net effect of the bad news, combined with overall weakness in the stock market, was a $20-billion drop in the market value of income trusts, which have become favourites of income-seeking investors.

Finance Minister Ralph Goodale says he wants to bring the uncertainty to a rapid conclusion, but it’s not clear how soon that will be. Ottawa has already imposed an end-of-the-year limit to receive submissions on its consultation paper. The result may be continued uncertainty.

In its consultation paper, Ottawa highlights three policy responses:

> Limiting the deductibility of interest expenses by operating entities. In this way, the operating entities would have smaller deductions, which would mean that they would be more likely to pay taxes. However, this response may do more harm than good, says Judith Harris, a tax partner at Osler Hoskin & Harcourt LLP in Toronto.

An income trust is a type of flow-through entity. Essentially, it owns debt and equity securities of an operating company. Income received from those investments flows out tax-free to trust investors, who ultimately pay the taxes. In a regular corporation, outflows to investors are taxed twice — once in the company’s hand and again when paid out to investors as dividends.

Harris says that flow-through entity models have evolved so that many FTEs do not use interest expenses to achieve flow-through treatment and tax efficiency. “Consequently, such a policy response would affect only some of the FTEs and is likely to create distortions in the market,” she says.

Further, says Simon Romano, a securities lawyer with Stikeman Elliott LLP in Toronto, such an option would be “very complex to introduce.” And, what’s more, it would be “arguably somewhat unfair to punish income trusts without punishing other highly leveraged businesses,” he says. “Limiting interest deductibility could reduce businesses’ willingness to invest generally, as it would raise the cost of capital.”

> Taxing flow-through entities in a manner similar to corporations. Implementing this option would mean a new tax would be imposed on flow-through entities, says Harris.
“Such a tax would reduce the cash flows available for distribution to investors and would probably have a very significant effect on the value of existing FTEs,” she adds.

But this policy response finds some support from Romano. He argues for what he calls a “modest proposal” of applying a 3% tax to the annual $10 billion in distributions paid out by income trusts, a proposal that would mean tax revenue would grow in line with the growth in income trusts.

“This tax would probably reduce the market value of income trusts by about 3%. All in all, a modest reduction that might be politically palatable,” he says.

Romano also notes that the estimated $300 million in federal tax revenue that the feds claim was lost in 2004 should be put in perspective: overall federal revenue is about $180 billion, while corporate income taxes bring in $30 billion.

> Making the tax system more neutral, with respect to all forms of business organizations by better integrating the personal and corporate tax systems. The existing dividend tax credit was designed to eliminate double taxation, but it hasn’t fully achieved that objective.

Harris argues that this idea is the preferred response, from a tax policy standpoint. “It would reduce the influence that the tax system has on capital formation and the choice of business organization,” she says.

@page_break@Ava Yaskiel, a securities lawyer and partner with Ogilvy Renault in Toronto, agrees.
“Absolutely, that is the right thing to do,” she says. “The fairest and best thing to do is for the government to harmonize the tax treatment of corporations and trusts.

“Corporations are penalized through a tax, both at the corporate and dividend level. As long as that persists, corporations and their shareholders suffer an unfair disadvantage in relation to income trusts,” says Yaskiel.

She says the current system of double taxation of dividends also makes some companies reluctant to pay out dividends: “It steers entities into a direction that may not be the best direction.”

There is a fundamental difference between the operations of companies and trusts, she notes. Double taxation is an incentive for companies not to pay out dividends, while trusts are formed for the express purpose of not paying taxes through a capital structure;
that means they pay out as much of the distributions as possible.

The full integration of corporate and individual tax returns, as far as dividends are concerned, could be achieved by eliminating the double taxation of corporate dividends.
One way to do this would be to make dividends a tax deduction for a corporation, but to require the individual to declare the dividends as income.

However, this route could be costly for Ottawa. Essentially, it would collect less tax revenue if double taxation is completely eliminated. Jon Kesselman, a professor of public policy at British Columbia’s Simon Fraser University, estimates that full dividend imputation — in which individuals are liable for the full taxes on dividends — would cost the federal government about $2.5 billion a year, or $1 billion more than the cost of
the current dividend tax credit system. IE