The false arguments that led to the tax on income trusts
The PM, some corporate CEOs, and government advisers argued that the reason for killing income trusts was 'tax leakage.' The evidence suggests far different motives.
By W.T. STANBURY
Published November 8, 2010
The Hill Times
The huge tax on publicly-traded income trusts announced by the Harper government on Oct. 31, 2006, involved three remarkable actions: deception, false arguments, and breach of fiduciary duty.
The deception was framed by Prime Minister Harper himself. The main stated reason for the new tax (alleged "tax leakage") was not the real reason. It was the reinvestment, growth and competitiveness (RGC) argument put forward by CEOs lobbying efforts. This has now been revealed by Lawrence Martin in his new book Harperland. The problem became, for the PM, one of corporate governance not taxes, reports Martin.
False argument #1 was the “tax leakage” justification for the new tax. It was demonstrated to be false by Dennis Bruce of HLB/HDR Decision Economics in his testimony before the Commons Finance Committee on Feb. 1, 2007.
False argument # 2 was made by the CEOs and directors who lobbied Harper and his senior advisers in 2006. Their RGC argument was a cover story for strongly self-interested objectives. The CEOs wanted to kill the income trusts because they threatened to reduce their discretion over net income after taxes, and because some CEOs faced direct competition from trusts which had a lower cost of capital. The CEOs’ lobbying was greatly assisted by very senior officials in the federal government who were predisposed to believe their arguments.
The CEOs who lobbied the government were breaching their fiduciary duty to their shareholders. The shareholders of many corporations wanted their corporation to convert to the legal form of an income trust in order to maximize shareholder value and produce higher payouts at a time of declining interest rates. Yet the CEOs lobbied to eliminate this option—and did so in violation of their primary fiduciary duty.
Note that three types of trusts were not made subject to the new tax: Real Estate Income Trusts (REITs); Licensed Limited Partnerships (LLPs); and non-publicly traded trusts.
Lawrence Martin’s Revelation
The key passage from Martin’s new book Harperland: The Politics of Control (Viking, 2010) on the income trust tax reads: “In fact, the government’s rationale for the flip-flop—the lost tax revenues—was not the real reason for it. When the announcement came, Tom Flanagan, still in Harper’s good graces at the time, asked him the reason for the reversal. ‘Well, when I was in opposition,’ Harper replied, ‘no one told me that all the big corporations were about to convert to the income trust form of organization.’ He wasn’t as worried about tax leakage, he explained to Flanagan, as he was about corporate governance. The income trust concept was fine, he believed when used in a limited sphere. But when it was beginning to be adopted by big manufacturers and service corporations, he was persuaded that it was the wrong way to go. James Rajotte, who served as chair of the [Commons] industry committee, was of the same impression. But it was not the case Harper and Flaherty put to the public because corporate governance was too complex an issue.”
False Argument #1: So-Called “Tax Leakage”
The “tax leakage” argument, while emotive and apparently understandable by the public, was based on the Department of Finance’s seriously flawed methodology of omitting deferred taxes. Further, Finance excluded the future effects of legislated cuts to the corporate income tax, and made other errors, all of which biased its estimate upwards. When Dennis Bruce corrected all the errors and included deferred taxes, there was no tax leakage in 2006, not $500-million as Finance had said. See his testimony before the Commons Finance Committee, and the news release of HDR/HLB Decision Economics on Feb. 1, 2007. However, the Harper government apparently believed that the “tax leakage” argument met the test of Prof. Tom Flanagan’s proposition that an argument “doesn’t have to be true. It just has to be plausible.”
Decoding “Corporate Governance”
The phrase “corporate governance” quoted above is a misappropriation of a term which usually refers to “the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled,” (Wikipedia).
In the taxation of income trusts issue, “corporate governance” subsumed two quite different things. The first was the real intent of the CEOs and corporate directors who lobbied secretly in 2006. They wanted to destroy an alternative form of business organization—income trusts—that was making their life uncomfortable. The second consisted of the set of arguments—relating to reinvestment, growth and competitiveness (RGC)—used by the CEOs and directors to justify government action, not just to stop the creation of new trusts, but to eliminate this form of business organization.
The CEO’s Agenda
The hidden agenda of the CEOs who sought to eliminate income trusts—as is often the case with lobbying—was entirely self-serving. In summary terms, the CEOs wanted to preserve their enormous discretion over the actions of the corporation, particularly how excess earnings are deployed. They opposed conversion to the trust form despite the fact that such businesses attained a higher market valuation and therefore a lower cost of capital—a crucial factor in head-to-head competition.
Many CEOs were under pressure to convert to income trusts. Gwyn Morgan, recently retired as president and CEO of EnCana Corporation, a leading energy firm, said that “it is fair to say that Canadian directors and management teams have increasingly been faced with shareholders who are demanding to know why their corporations were not converting to a trust,”(The Globe and Mail, Nov. 2, 2006). Investors (particularly seniors) very much liked the idea of larger and steadier payouts of earnings , particularly when faced with a period of declining interest rates.
Why was the trust form an anathema to some CEOs? Business columnist Diane Francis (Financial Post, Dec. 2, 2006) emphasized that in the “real world…corporate managements usually deploy their cash surpluses to overpay themselves. Then they often get involved in unproductive, but tax-efficient, endeavours such as buying back stock, which, not coincidentally, also enhances the value of their own wallets. In addition, corporations use surplus cash to make sometimes foolish diversifications, acquisitions or sub-optimal investments in their own businesses.”
The key change in converting a business to the trust form was that the business is legally required to distribute annually all of its income after deducting capital cost allowance (a non-cash expense) and certain other items. Thus net new investment requires the CEO of a trust to raise money in the capital market. CEOs of regular corporations can use retained earnings (i.e., net income after taxes minus dividends).
I now discuss the lobbying by some CEOs in 2006, and after that I examine the arguments they made to kill the trusts.
Lobbying by CEOs in 2006
From the public’s perspective the trust issue “went dark” once the Harper government assumed office on Feb. 6, 2006, following the Conservatives’ repeated election promise to “never tax income trusts.” The new government made no effort to conduct a public consultation process (as had the previous Liberal government in 2005) when the trusts issue heated up again in mid-2006.
In retrospect, we learned that during 2006 certain CEOs and directors were able to lobby the minister of finance, senior officials, and even the PM. On Nov. 2, 2006, The Globe and Mail reported that “High-profile directors and CEOs, meanwhile, had approached Mr. Flaherty personally to express their concerns: Many felt they were being pressed into trusts because of their duty to maximize shareholder value, despite their misgivings about the structure,” (by Sinclair Stewart and Andrew Willis, “Income-trust crackdown: The inside story”).
The minister of finance himself revealed the lobbying by business leaders when responding to questions before the Commons Finance Committee on Jan. 28, 2007: “I had communications with these companies[not identified]… . I had directors of other companies[not identified ] talking to me and saying to me, “Jim, you know what’s happening out there. We’re being pressured to convert to income trusts by our shareholders because of a tax loophole. And is that the right way to run our businesses?” I had directors saying to me, “I don’t want to vote in favour of this corporation that I’m a publicly traded corporation that I’m a member of the board on. I’m an experienced business person. I don’t think the income trust is the right thing for this ongoing operation. But the shareholders do because they can get greater returns in that structure.”
There was no counter-lobbying in 2006. That would have allowed other views and actual facts (as opposed to mere opinion) to be heard by the government, as there had been when the Liberals reviewed the regime for income trusts in 2005 (see De Cloet, Chase, and Stewart, The Globe and Mail, Oct.11, 2005.)
The CEOs strongly preferred to exercise influence in private. Finance Minister Jim Flaherty noted that “What I find troublesome, quite frankly, is that I have CEOs of banks, and leaders on Bay Street who have said to me, privately, absolutely it was the right thing to do. But they don't go out publicly and say the same thing. And that is one of the burdens that one bears in public life,”(National Post, June 9, 2007).
The lobbying effort probably went into high gear on Sept. 11, 2006 when Telus Corporation announced its intention to convert to a trust. The intensity likely increased when BCE Inc., one of the largest businesses in Canada, announced on Oct. 11 that it was converting to a trust.
Which CEOs Lobbied?
We know the names of only a few of the CEOs who lobbied on the income trust issue in 2006.
Paul Desmarais Jr., “the well-connected chairman of Power Corp. of Canada, even railed against trusts in a conversation with Prime Minister Stephen Harper during a trip to Mexico [in late March 2006 ], and told him he should act quickly to stop the raft of conversions, according to sources,”(Stewart and Willis, The Globe and Mail, Nov. 2, 2006). One of Power Corp’s largest subsidiaries, Power Financial, was facing very tough competition in the retirement products market from CI Financial which had converted to trust status in June 2005. As a trust, CI was able to raise capital at a lower cost than Power Financial which chose to remain a corporation.
Dominic D’Alessandro, CEO of Manulife Financial, was said to have met with the finance minister and argued for taxing income trusts. (He later testified before the Commons Finance Committee on Feb.1,2007.) Just like Power Corporation, Manulife was also facing intense competition from CI Financial. He was an up-from-the- street man who rose quickly within Manufacturers’ Life and made it grow rapidly. In general, he was among the most aggressive and outspoken of financial industry CEOs. D’Alessandro was then registered under the Lobbyists Registration Act, but Paul Demarais Jr. was not. (Note, however, if an executive spends less than 20 per cent of his time on lobbying activities, he need not register under the Lobbyists Registration Act.). D’Alessandro would likely have had a high level of face validity because he was the close runner-up for most respected CEO of the year in 2005 as voted by 250 of his peers.
EnCana Corporation had consulted officials in Finance as early as 2004 about putting some of its mature assets into an income trust. By the fall of 2006, EnCana on the verge of a decision to create an income trust. It would have been a huge deal (see The Globe and Mail,Nov.4,2006;and CTV News,Nov.6,2006). Gwyn Morgan, the former CEO of EnCana, but still a director, loathed the idea—despite the fact that it meant great things for EnCana’s public shareholders. Creating a trust would generate a large amount of cash for EnCana to put into exploration and development, and possibly acquisitions.
Just before the EnCana board meeting in the fall of 2006, at which the decision to create an income trust was to be made, industry insiders indicate that Morgan alerted the Finance Minister (and possibly the PM) of EnCana’s plans, and requested that the deal be blocked.
When Gwyn Morgan lobbied to eliminate income trusts, he had enormous face validity for several reasons: (i) He was one of Harper’s few close friends from the days they both lived in Calgary; (ii) As its CEO until the end of 2005, Morgan had been the driving force in the growth of EnCana Corporation and built it into the biggest independent oil and gas producer in North America. In October 2005, EnCana had a market value of $50-billion. (iii) A poll of 250 CEOs had named Morgan the Most Respected CEO among his peers in 2005, according to the 11th Annual Canada’s Most Respected Corporations Survey. (iv) On April 26, 2006, Harper had nominated Morgan to be the chair of newly-created Public Appointments Commission (PAC). However, less than three weeks later, Morgan had been rejected by the Commons Public Accounts Committee reviewing his nomination , deeming him “unsuitable” for the post. Morgan made no public complaint (although the PM decided not to set up the PAC).
The prospect of another huge income trust conversion was exploited by those intent on killing income trusts to foment a sense of alarm at the highest levels of the Harper government. The announcement of EnCana conversion would have closely followed the Telus (Sept. 11, 2006) and BCE (Oct. 11, 2006) announcements (see Stewart, Willis, and Ebner, The Globe and Mail, Nov. 4, 2006).
CCCE’s Notable Silence
At the time of the lobbying, Desmarais, and D’Alessandro were the two vice-chairs of the Canadian Council of Chief Executives (CCCE), arguably the most influential lobbying organization in the capital. However, CCCE was conspicuously quiet on a new tax that wiped out $35-billion of stock market value within three weeks. CCCE’s decision to stay silent on the tax caused considerable friction and one of its members quit—an unprecedented action.
The Reinvestment, Growth and Competitiveness (RGC) Argument
Smart lobbyists understand that they must offer arguments to persuade senior officials and their political masters to have government deliver what they want. Lobbyists also understand the importance of supplying the deciders in government with a rationale for government action that will be at least plausible to the public. The two sets of arguments may be different. In either case, the argument may be false (but appealing).
Information provided in confidence by a source close to the scene at the time indicates that the most important reason why the minister of finance, and the Prime Minister, decided to reverse the Conservatives’ promise not to tax income trusts was the belief that trusts had a lower rate of reinvestment of their earnings (because they are obligated to distribute all of their earnings to unit-holders, albeit after capital cost allowance). Capital investment is an important determinant of productivity growth which is the main basis of increases in the real standard of living. Thus—it was argued—the conversion of major corporations to income trusts would slow the rate of economic growth.
This was the argument pressed on the minister and the PM by the CEOs and directors—and it was echoed by the most senior advisors (see below). It was based on a few emotive phrases: investment, growth and competitiveness. Gwyn Morgan put it more tentatively than most when he said: “the most important concern” about the growth in the number of income trusts lay in possible decline in “national competitiveness.” He said, “research, reinvestment and growth are crucial to the future living standards of all Canadians. To the extent that trusts may have limited these things, the government had reason to be concerned,”(op ed., The Globe and Mail, Nov. 2, 2006).
He, like every CEO who made essentially the same argument, offered no hard evidence, nor any independent analysis. It was simply the conventional wisdom—but it was intuitively appealing. In my view, it was a false argument.
Contrary Evidence and Analyses
I now review the contrary analyses beginning with the formal examination into this matter by two groups. The first was global accounting firm PricewaterhouseCoopers (Income Trust Study, December, 2006). It concluded that “A review of Canada’s more than 250 income trusts indicates that trusts have been making an important contribution to the economy, investing their capital and growing their businesses at impressive rates. In 2005, trusts enjoyed (year over year) sales growth of 54 per cent to $74.3-billion, while net income improved 62 per cent to $10.6-billion, capital investment totaled $26.5-billion in 2005, or 230 per cent of net income. These findings are counter to the contention of the federal government that income trusts do not reinvest in their business and amount to a long-term-dead end for Canadian businesses.”
The second study was by the major consulting firm HDR/HLB Decision Economics (Income Trusts and the National Economy, April 6, 2006). It concluded that “The evidence amassed in this study demonstrates that the public policy concern over trusts negatively effecting productivity is not only unwarranted, but that suppressing growth in the trust sector—by means of law, regulation or taxation policies—could be tantamount to suppressing growth in the Canadian economy.”
Further, Andrew Sharpe, described as “one of Canada’s foremost productivity experts and the head of the Centre for the Study of Living Standards based in Ottawa.”… said, “I don’t really think there’s any strong evidence that income trusts are hurting Canada’s productivity.” Further, “the evidence on productivity points elsewhere: to traditional companies in Corporate Canada, whose records on investing profits in innovation and competitiveness are on shaky ground,”(Heather Scoffield, The Globe and Mail, Nov. 2, 2006).
Professors Sean Cleary and Greg MacKinnon of the Sobey School of Business at Dalhousie took exception to the CEO’s argument against trusts to the effect that “by paying out earnings and not reinvesting in their businesses they will hamper growth in the economy. It is impossible to know if this is true. While trusts generally do not reinvest their profits to finance growth, trusts can (and many do) raise external funds to finance growth by simply selling new units to investors. Most experts will agree that having to go back to the markets to raise new funds is generally beneficial since it provides discipline for managers and it prevents them from wasting resources on inefficient businesses,” (The Halifax Chronicle-Herald, Nov. 9, 2006).
Help From Senior Officials
The CEOs were aided in their efforts to kill income trusts in that their argument resonated strongly with the most senior officials advising the PM, namely Kevin Lynch, then clerk of the Privy Council, and Mark Carney who had responsibility for the income trust file within Finance.
I have been told that Mark Carney put forward the reinvestment, growth, competitiveness argument to Flaherty. Almost simultaneously Lynch made the same argument to Prime Minister Harper.
Lynch was clerk of the Privy Council from March 2006 to June 30, 2009, and formerly DM of Industry (1995-2000) and later of Finance (2000-September 2004), and believed he was a guru on RGC matters. While serving as deputy minister of Industry from 1995 to 2000, Lynch became greatly concerned about the “productivity gap” between Canada and the U.S. Lynch pushed the PMO for action. The issue morphed into the “innovation agenda,” and Lynch championed increased research spending, Internet access for schools, and the Canadian Research Chairs program, aimed at stemming the “brain drain.” (www.macleans.ca
Carney was appointed senior associate DM of Finance in November 2004. As head of the tax policy branch, he was responsible for the income trusts file. On Oct. 11, 2005, The Globe and Mail reported that Carney “did not buy the line that income trusts are good for productivity because they encourage corporate managers to be more disciplined when making investments.” Further, he “doesn’t believe that income trusts help the Canadian economy because they don’t encourage reinvestment,” (De Cloet, Chase, and Stewart). In October 2007, Carney became governor of the Bank of Canada with the strong support of Flaherty (CTV.ca News Staff, Oct. 4, 2007).
Brent Fullard, founder and president of the Canadian Association of Income Trust Investors, argues that Carney came into Finance strongly biased against income trusts. That bias was developed because Carney’s entire background in finance consisted of working for Goldman Sachs, an institutional dealer with no retail clients. Many of Goldman’s important clients wanted to eliminate the trust model and continue with business as usual under the corporate model. To protect its own interests, Goldman took up their cause with enthusiasm.
In summary terms, the RGC rationale put forward by the CEOs lobbying the Harper government in 2006 to get rid of income trusts was both self-serving and unsupported. The best analyses and research available did not support the CEO’s claims. However, their arguments were simplistic and intuitively appealing, and they were reinforced by the most senior officials. Most importantly, the RGC arguments were sufficient to convince the inexperienced PM.
New, Young PM Faces His First Big Challenge
When he started dealing with the trust issue in mid-2006, Stephen Harper had been PM for only about five months, and he was 47 years old with no background or experience in the capital markets into which he was about to meddle on a large scale. The transition from opposition leader (which he became in May 2002) to PM is a huge one.
Harper quickly adopted a highly-centralized system of decision-making in which he was (and still is) “the decider.” Above all, the new PM sought complete control over his government’s communications.
As PM, Harper became the “centre of the Ottawa universe.” The business executives who had refused to help finance the Reform Party (of which Harper had been a founder in 1987) and its successor the Canadian Alliance, were now paying court. No doubt the CEOs laid on the flattery with a trowel. Aided by senior officials, their lobbying efforts were successful.
Breach of Fiduciary Duty
I believe that the CEOs and directors were violating their primary fiduciary duty to shareholders to maximize shareholder value by lobbying to eliminate the income trust option. They ignored the demand by their shareholders to at least carefully study the option of conversion, or putting some of the corporation’s assets into a trust as EnCana was planning to do in the fall of 2006. The success of the CEOs' lobbying efforts denied their shareholders a legitimate opportunity to achieve higher returns on their investment.
The announcement of the new tax on certain income trusts announced on Oct. 31, 2006, was a brutal “remedy” to a non-problem when we strip away the flawed methodology and errors in Department of Finance’s estimates of “tax leakage” for 2006. By announcing a moratorium, the minister of finance could have stopped the creation of new trusts, and grandfathered the existing ones. However, that would not have met the objectives of the CEOs who lobbied the Government in 2006.
We now know that “tax leakage” was not the real reason for the tax. It was based on arguments relating to reinvestment, growth and competitiveness. Those arguments—pushed by CEOs —were not supported by the best available studies or analytical reasoning.
The tax has rightly been called a public policy “train wreck” for three main reasons: (i) the predictable adverse policy outcomes, notably the $35-billion loss it created for some two million Canadians along with the loss of a very popular retirement income investment vehicle; (ii) the deplorable process by which this policy came into existence; and (iii) the subsequent huge reductions in tax revenues when the crippled income trusts were acquired by sovereign entities, and by foreign private equity firms. It was not the wealthy, but ordinary Canadians—patrons of Tim Hortons—who have paid the huge bill.
W.T. Stanbury is professor emeritus, University of British Columbia.
The Hill Times
Monday, November 8, 2010
Posted by Brent Fullard at 8:31 AM