EFFECTS ON STRUCTURE, CONDUCT AND PERFORMANCE
P. L. ARYA Abstract: Income trust as a business structure became increasingly popular in Canada since 2003. Income trust structure gave companies advantage of shifting their tax burden on to the investor. The investor, on the other hand, received steady and higher than the market rate of return on invested capital and also received capital gains in the form of ‘return of capital’. When large Canadian corporations were in the process or changing their structure from public corporations to income trusts, the government of Canada in a sudden shift of policy announced that it would remove the tax advantage of income trusts and put them on equal footing with Canadian corporations. This announcement in October 2006 had implications on the structure, conduct and performance of Canadian industry. The purpose of this paper is to analyze reasons for change in the government policy and the effect of the new tax policy on the structure, conduct and performance of Canadian industry.
Businesses which have achieved high profits and maturity, with moderate growth prospects, have adopted income trust structure to become tax efficient. Under this structure, the income trust, which has a business, sells units in the stock market to raise its capital. The unit holders receive two types of payments; (a) return on their units and, (b) return of capital. Return on units is treated as interest income for tax purposes and depending on income of persons, the marginal tax rate may be around 45%. The return of capital part is treated differently. The investor is to deduct this amount from the cost of units he had bought. This becomes a taxable capital gain at the time of sale of the units. Normally capital gain tax works out to be around 25%. The income trust units retain some of the earnings for further growth and, after deducting expenses, pay out most of their income (high pay-out ratio) to the unit holders. The pay-out ratio of income trusts varies between 50 to 80%. That is why income trusts are also called flow-through entities. Income of businesses flows through a trust to investors. The income trusts units are held by two types of investors: (a) those who are old and drawing pensions and (b) those who want regular monthly income rather than buy and sell shares and face market fluctuations. The average rate of return on income trust units before October 2006 was in excess of 10%. Some foreign investors got attracted by the rate of return and started buying Canadian income
trust units. In 2006 the banks were giving low rate of interest. On saving deposits it was less than 1% and on GIC’s it was about 2%. Bonds were also giving low interest. Most Canadian corporation gave zero to very low dividends to investors. The corporate philosophy is that they give growth, i.e., when share price rises the investor sells and gets capital gains. Some provinces (Ontario, Alberta and Manitoba) passed law to make investment in income trusts safer. Prior to 2004 investment advisors advised investors to stay away from income trusts as they were deemed risky because of liability issues. The passage of law in 2004-2005 to make liability restricted to the value of the shares made investment in them attractive. Canadian investors were increasingly becoming attracted to the high rate of return on income trusts units and tax deferral aspect of return of capital amount. The money started pouring into income trusts and out of the corporate structure.
The First Shock:
The perception of tax leakage was on the mind of Ralph Goodale, the Finance Minister at the time of the budget 2005, when he wanted to introduce a bill to tax flow-through entities. However, the Government of Canada, at that time, wanted to consult stakeholders before making a shift in policy and taxing income trusts. It brought out a White Paper titled: “Tax and Other Issues Related to Public...