The Hill Times: Income trust tax needs to be repealed

Income trust tax needs to be repealed
The Harper government must come clean on its allegations of tax leakage, since it is the policy that is causing tax leakage.

By: Brent Fullard
The Hill Times
March 9, 2009

TORONTO—Can bankers meet the financing needs of corporate Canada? This is the topical question that was posed in the Financial Post on Feb. 22, 2009, and which should be on the minds of every politician and policy maker in Ottawa

In short, the answer is no.

Meeting the financing needs of corporate Canada requires that a full suite of financing options be available to corporations, that will allow them to sustain themselves over the full business cycle. Actions by the Harper government have served to limit the financing choices that are available to corporate Canada. These actions have significantly reduced the availability of much needed capital to Canadian businesses, as I shall explain below.

A full suite of financing options to corporate Canada is necessary as to the health and vibrancy of the private sector what a deep gene pool is to enhancing the survival of species in the natural world. Diversity is strength.

The over reliance on debt in the corporate sector, motivated by a desire to increase equity returns for shareholders, is proving itself to be as imprudent a strategy for business as it has been for consumers. The examples of over reliance on debt financing are all around us. Canwest Global has seen itself become a penny stock on the verge of bankruptcy after binging on acquisitions funded solely through billions in debt. The once icon of corporate Canada, Nova Chemicals, is being sold to Abu Dhabi’s IPIC: Nova’s excessive debt burden is cited as the impetus for the sale. The approval of BCE’s debt leveraged buyout by then Industry Minster Jim Prentice was oblivious to the fact that Canada’s largest telco would have been insolvent from the get-go, with $35-billion of debt as a result of its leveraged buy-out. Fortunately, others more mindful of that reality stepped in to prevent this adverse outcome.

By definition, making capital available to Canadian enterprise requires that the investment be attractive to both the capital provider and the capital user. However, policy makers in Ottawa arbitrarily decided to kill a new form of investment capital, namely income trusts that had proven popular with the providers of capital, in particular Canadian and U.S. retail investors, seeking income for retirement, as well as with capital users. The income trust market had grown to over $200-billion and, prior to the Halloween surprise of 2006, was responsible for more than 50 per cent of new issue capital being raised in Canada, and which fell to zero immediately thereafter. Income trusts were a unique evolutionary product of the Canadian capital markets that incorporated the hybrid attributes of both debt and equity. Like debt, income trusts provided investors with much sought after investment income. Importantly however, unlike debt, the distributions on income trusts are not obligatory payments for the issuer. Hence, failure to pay, will not throw a company into bankruptcy.

Furthermore, unlike debt, income trust units have no fixed maturity date that requires the repayment of principal. Therefore, there is no chance for default causing bankruptcy. The corollary, however, for investors, is that by having no maturity date, investors avoid reinvestment risk, and income trusts are able to increase their distributions in line with the real growth of their available cash flow. This provides a built-in mechanism for inflation protection and the potential for equity like returns.

The Harper government’s rationale for killing income trusts—by a 31.5 per cent tax on their distributions—was premised on the unproven argument that income trusts cause tax leakage and that income trusts somehow had a negative effect on the economy. Both of these propositions are false They have been refuted by every credible study performed to test these arguments. Having created a market that reached a scale of $200-billion in the fall of 2006, generating underwriting fees in excess of $5-billion between 1996 and 2006, the banks as major participants of the Canadian capital markets were notably conspicuous by their absence when Finance Minister Jim Flaherty’s income trust tax was announced on Oct. 31, 2006. Further, there was absolutely no public consultation. The new tax was premised on arguments that the Canadian banks knew to be patently false, most notably the one about tax leakage.

Could it have been that Canadian banks began to fear the competitive threat that income trusts represented to their mainline business of debt lending? Did the Canadian bank oligopoly fear that Canadians retail investors would “disintermediate” them from their traditional lending business? Were the banks concerned that income trusts were more in keeping with a “buy-and-hold” strategy, and so were not able to provide for the ongoing generation of bank brokerage fees, normally associated with the “buy-and-sell” strategy of common shares?

Whatever the reasons and whatever the rationale, the point is simply that income trusts need to be restored for a whole host of reasons that I can only sketch here. First, there never was adequate policy justification or proof to support their elimination by the Harper government in the first place. Second, the 75 per cent of Canadians without defined benefit pensions who must save for their own retirement have been denied an essential means of providing income in a protracted low interest rate environment, that was preserved for the 25 per cent of Canadians with pensions, who can own private income trusts free of the draconian 31.5 per cent tax. Third, corporate Canada is being denied a robust source of investment capital that afford them “market completeness,” and that is better able to sustain itself over the market cycle, without introducing the systemic risk of additional debt, the dimensions and severity of which are now coming home to roost.

The good news is that the punitive income trust tax does not come into effect for trusts until January 2011. The tax needs to be repealed to the benefit of all Canadians. At the very least, the Harper government must come clean on its allegations of tax leakage, since it is the policy that is causing tax leakage and not income trusts themselves. Can a policy’s outcome be further from its stated objective than that?

Brent Fullard is President of the Canadian
Association of Income Trust Investors.

news@hilltimes.com
The Hill Times