Monday, May 4, 2009

Flaherty's income trust tax totally flies in the face of advice and warnings of TD Bank Financial Group

TD Bank Financial Group Submission to the Department of Finance on Flow Through Entities:


As the withholding tax rate is set by treaty and Canada does not have the discretion to make the unilateral change, a distribution tax that is credible to Canadians is the only viable option for addressing the concerns above.[not what Flaherty did], but what the Liberals’ policy consists of). At this point we must return to one of our original points of “do no harm”. [as distinct from the $35 billion loss inflicted by Flaherty] A distribution tax would inevitably reduce demand for FTEs and hence lower their market value. Further, it would provide a competitive edge to private LBOs, performed mainly by U.S. Equity firms, at the expense of Canadian-made income trusts [when this occurred Flaherty declared “It’s not my fault”] Lower market values would wipe out the wealth of Canadians and cause a revenue loss to the federal government. Hence, we must be very careful that any policy move does not have the ultimate result of hurting Canadians.(not a concern to Flaherty) This really comes down to who has significant influence over the valuation of the FTEs. In the case of energy trusts this is likely foreigners. For energy trusts as a whole, foreign ownership is nearly 50 per cent and for some trusts it greatly exceeds 50 per cent. So if the distribution tax is very large, the market values would plummet and Canadians would be badly hurt. Foreign ownership of business income trusts is quite low. Therefore, a distribution tax on this form of FTE would not likely greatly affect market values, but then neither would it address the concerns set out by the Department of Finance. Foreign ownership of REITS lies between the situation of business income trusts and energy trusts.

If the advantage to an American investor of buying a Canadian FTE is about 30 percentage points over an American equity, then on the surface there would seem to be the scope to levy a distribution tax without greatly impacting foreign demand. A 15 per cent tax, for example, would still leave half the original edge. But it is possible that any distribution tax could result in a reduction in Canadian welfare. In other words, the capital losses from lower market values would exceed the present value of higher federal tax revenues (which themselves would be lowered by the tax implications of the capital losses). A corollary of this point is that when one considers a broader welfare perspective, it is not clear that the holdings of foreign investors in FTEs is causing a revenue loss to Canadian governments.

The above arguments suggest that a distribution tax effectively targeted at foreigners would be counterproductive to Canadian interests. The same arguments can be made for a tax that would target the Canadian tax-deferred sector. Again the superficial appeal of such a tax is understandable. With the federal corporate income tax rate cut, the tax-deferred sector would enjoy about a 32 percentage point edge with income from an FTE (depending upon the province and its corporate income tax rate). However, as with the case of foreigners above, we must consider a broader context.

While foreign demand is concentrated in energy trusts, the Canadian tax-deferred sector likely looms large in determining valuations of business income trusts. If any distribution tax were not creditable to the tax-deferreds, market values could greatly fall and badly hurt taxable Canadians.[Liberals 10% tax is refundable to tax deferreds] If non-taxable entities essentially determine the market for business trusts and overall equity, such a distribution tax could raise the cost of capital for all firms. Further ,any tax in income trusts might simply cause a substitution to entities avoiding corporate taxes by purchasing debt and using LBOs as a substitute for an income trust. A welfare loss would also be inflicted on Canadians if the pension funds substituted offshore holdings for Canadian FTEs.

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