The Canadian Experience with Income Trusts

Outline

• What are income trusts?

• Tax policy implications

• Experience in selected countries

• Revenue implications and economic efficiency issues

• Recent developments

• Questions

Collective Investment Vehicles in Canada

• Trusts widely used as a collective investment vehicle in Canada

• Mutual funds are generally established as trusts – Mutual funds hold portfolio of public stocks

and bonds

What are Income Trusts?

• Trusts governed by provincial laws

• Ownership vehicle for a business– Ownership of a single company rather than

shares of a portfolio of companies – designed to eliminate corporate income tax on

the underlying business

• Raise funds by selling units in the trust to public investors.

REIT

OperatingCorporation

Trust

Lease paymentsLease

Cash DistributionsTrust Units

Unitholders

• Trust has a leasehold interest in properties held by the operating corporation

• Trust receives lease income

• Lease payments are deductible by the operating corporation

Energy (Royalty ) Trust

Operating Corporation

Trust

Royalty Payments

Cash Distributions(income and return of capital)

Unitholders

• Trust has a royalty interest in properties held by the operating corporation

• Trust receives royalty payment

• Royalty payments are deductible by the operating corporation

Business Income Trust (First Generation)

• Trust owns an operating corporation

• Operating corporation issues subordinated debt to trust

• Operating corporation pays interest to the trust and does not pay corporate tax

Unitholders

Corporation

Trust

Interest/ Royalty/ Lease payments, Dividends and Return of Capital

EquityDebt Royalty interestLease

Trust Units Cash Distributions(income and return of capital)

Business Income Trust (Second Generation)

• Operating corporation replaced by limited partnership (because of flow-through nature of partnership)

• Operating trust sits in between limited partnership and income trust to avoid foreign property limit applying to Canadian pension plans (public and private)

Source: RBC Capital Markets

Income

Trust

Unitholders

Limited Partnership

Operating

TrustGeneral Partner(Corporation)

Business Income Trust(Third Generation)

• Foreign property limit repealed in the 2005 budget

• Operating trust not required

Source: RBC Capital Markets

Limited Partnership

Unitholders

General Partner(Corporation)

Income

Trust

Recent Growth

• Energy trusts and REITs since mid 1980s

• Business income trusts are more recent.

• Market capitalization was $193 b at end of 2005 (11% of S&P/TSX); up from $18 b in 2000.

• Could continue growing (listing on S&P/TSX and provincial limited liability laws)

-

40

80

120

160

200

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Energy trusts

Business trusts

REITs

Limited partnerships

Types of Income Trusts

Trusts ($ million) (%)Energy (Oil and Gas royalty) 36 79,493 41.0%REITs 25 21,781 11.2%Business Income Trusts 173 92,531 47.7%- Power & Pipelines 22 19,690 10.2%- Industrial Products 31 17,447 9.0%- Media, Telecom Entertainment 17 14,805 7.6%- Consumer Products 33 10,103 5.2%- Energy Services 14 9,420 4.9%- Transportation / Storage 18 8,934 4.6%- Marketing /Distributions 5 5,758 3.0%- Professional Services 9 2,768 1.4%- Food Products 16 2,559 1.3%- Restaurents (royalty paying) 8 1,047 0.5%

234 193,805 100.0%

Tax Policy Implications

• Income trusts deduct distributions to investors (unit holders) in calculating taxable income of the trust– Trust pays income tax (top personal rate) on taxable

income – Taxes paid depend on investor (Canadian retail, tax-

exempt (e.g., pension funds), non-residents

• Corporations pay corporate income tax and shareholders pay tax on dividends– Cases of over and under integration in Canada

Experience in Selected Countries

• U.S. generally treats flow-through entities as corporations– exceptions include REITs and certain partnerships

• Since the mid-1980s, Australia has taxed certain publicly listed vehicles as corporations– However, Australian tax system fully integrates the

personal and corporate tax systems.

• The U.K. recently announced a tax regime for REITs

Tax Revenue Implications

• Estimated impact on federal tax revenues was $300 m in 2004 (approximately 1% of federal corporate tax revenues)– Business trusts accounted for $120 m– Estimate compares income tax under the corporate

structure and income trust structure

• Estimate sensitive to certain parameters (e.g. tax-exempts)

• Provincial government implications as well• Estimate for 2005 is higher (60% growth since 2004)

Economic Efficiency Issues

• Some have said that income trusts lead to greater economic efficiency

• Others have said that the tax system may reduce economic efficiency by distorting investment decisions

Recent Developments

• Canada recently carried out consultations on income trusts (and limited partnerships)

• Important public policy issue in Canada• Views on both sides of the issue

– Some see income trusts as positive development and low risk to government revenues

– Others see potential risk to economic growth, investment, productivity and tax revenues

Issues

• Issues that were raised as part of the consultations were:– impact of their tax treatment on how businesses

are organized in Canada• economic growth, investment and productivity

– impact on government tax revenues– potential role tax-exempt investors may have in

this market

Government Response

• Better integration of the personal and corporate income tax systems– Increase the dividend tax credit for dividends

from large corporations to fully compensate investors for underlying corporate income tax

– Takes into account recent proposals to reduce corporate income tax

Questions

• What is the experience in other countries?

• What actions are being/have been taken?

• Views on integration?

• Views on pressures on the debt/equity borderline?