Mintz text on revenue cost of income trusts
By Jack M. Mintz (1)
The recent announcements by TELUS and BCE have given rise to the question as to how much federal and provincial taxes have been reduced by corporations converting into income trusts. Since the time of my last estimate of about $500 million in the fall of 2004 (2), the income trust market has grown by about a third from $62 billion to $83 billion (3) in issuance. With TELUS and BCE conversions, expected to be close to $48 billion, the income trust market will have more than doubled since 2004. However, during the past two years, federal and provincial governments have reduced corporate income tax rates and increased the dividend tax credit for large companies, thereby reducing the revenue effects that arise from corporations converting into income trusts.
Overall, the tax savings for investors has substantially increased since 2004. As to be documented in more detail below, I estimate the total reduction in federal and provincial taxes to be $700 million annually up to now. With the proposed trust conversions, the total federal and provincial tax reductions for investors are expected to be $1.1 billion annually.
Estimating the revenue impacts of income trusts conversions requires data that are sometimes difficult to obtain (4). The basic exercise is to consider how income trust conversions impact on tax revenues paid by business, investors with taxable accounts, pension and RRSP account holders and non-residents. By converting to a trust, a business is able to avoid payment of corporate taxes and investors no longer pay personal taxes on corporate dividends and appreciation in share values. However, investors will pay personal or withholding tax on income trust distributions that are typically more than the personal tax that would have been owed on preferentially-taxed corporate dividend and capital gain income.
About two-thirds of income trust distributions are in the form of ordinary income that is fully taxed in the hands of taxable investors who would have received dividend and capital gain on corporate shares that are more favourably taxed.
Pension plans and RRSP account holders do not pay tax on income received from corporations or income trusts. These investors save corporate tax with income trust conversions although one might consider an annualized revenue gain in greater pension and RRSP withdrawals arising from a higher yield on trust investments.
Non-residents pay withholding taxes at a rate of 15 per cent on corporate dividend and income trust distributions.
Governments receive capital gains taxes on conversions to trusts. However, these are one-time revenue flows that must be annualized to be included with yearly flows of taxes paid.
Notes to the attached table provide more details on the data used for estimating revenue effects.
As of now, the estimated reduction in corporate taxes is $1.8 billion with an increase in net personal and withholding taxes paid on trust distributions equal to $1.1 billion, for a net tax reduction of $700 million annually. Taking into the TELUS and BCE trust conversions, corporate tax reductions are expected to $2.8 billion with a personal and withholding tax pick up equal to $1.7 billion, resulting in a tax cut equal to $1.1 billion annually.
Looking at the perspectives of each type of investors provides some useful information.
As a result of moving to a two-tier dividend tax credit to equalize taxation of corporate and income trust distributions, it is not surprising that there is little net tax reduction for taxable investors when companies convert to income trusts. For these investors who hold 39 per cent of trusts, their share of the reduction in corporate taxes equal to $700 million is offset by higher federal and provincial personal taxes of almost the same amount.
For pension and RRSP account holders, also estimated to hold 39 per cent of trust units, the tax cut is largest. Their share of the reduction in corporate tax revenues is equal to $700 million for trust conversions so far. If it is assumed that a higher yield on income trusts provides greater retirement income in the future for investors (5), additional personal tax revenues, on an annualized basis, would be $200 million for current trust conversions, resulting in a net loss of $500 million annually. With the TELUS and BCE conversions, the share of the corporate tax reduction grows to $1.1 billion, offset by greater taxes on pensions and RRSP accounts equal to $300 million annually. The annualized net reduction in taxes paid by pension and RRSP accounts is equal to $800 million once including TELUS and BCE.
The tax cut faced by non-resident owners, holding about 22 per cent of trust units, is smaller than for pension plans and RRSP account holders at this time. So far, the non-resident share of corporate tax reduction is $400 million, offset by additional withholding taxes of $200 for a net reduction of $200 million annually. With the TELUS and BCE conversions, corporate tax reductions rise to $600 million, offset by $300 million in withholding taxes for a net reduction of $300 million annually. If non-resident ownership increases substantially in the future, the net reduction in federal and provincial revenues will become more significant.
The above estimates of tax changes do not take into dynamic effects through increased investment as it is assumed that the gains go primarily to investors through higher yields on savings.
Specific provincial effects have not been estimated. Alberta is especially affected by trust conversions since its share of the corporate tax base is over one-fifth of the Canadian base while Alberta hold less than ten per cent of units when taking into account both Canadian domestic and non-resident ownership.
Overall, the revenue loss is not large compared to the almost annual $500 billion of federal and provincial revenues raised today. However, as the income trust sector grows, it will be important to evaluate as to whether this tax cut is more efficient compared to other growth-oriented policies.
|With TELUS and BCE
|Pension and RRSP
|-Personal and Other
All numbers have been rounded off to nearest 100 million.
Earnings before interest, taxes and depreciation of income trusts estimated to be $18.7 billion by September 2006, based upon growth in income trust issuances. Payments to third parties are estimated to be $3.1 billion and to unit holders $11.9 billion. With TELUS and BCE conversions, earnings before interest, taxes and depreciation are estimated to be $29.1 billion with third party payments equal to $4.8 billion and payments to unit holders equal to $18.5 billion.
Of distributions, 66 per cent is in the form of ordinary income, 4 per cent in dividends and 30 per cent in return of capital.
Unit trusts are estimated to be owned according to the following distribution: taxable investors (39 per cent), Pension Plans and RRSP accounts (39 per cent) and non-resident investors (22 per cent).
Federal and provincial corporate taxes are estimated to be 9.7 per cent of earnings before interest, taxes and depreciation, taking into account corporate tax changes and provincial capital taxes.
Personal tax rates for taxable investors are estimated as 40 per cent on ordinary income, 13.8 per cent on dividends (reflecting new dividend tax credit regime) and 16 on accrued capital gains.
It is assumed that corporate tax efficiency gains increase pension and RRSP investment income on an annualized basis. The additional retirement payments are taxed at 34 per cent with the gain reflecting the 9.7 per cent corporate tax rate on earnings.
Non-resident investors pay a 15 per cent withholding tax on corporate dividends and income trust distributions to the federal government.
Transitional capital gains are taken to be 13 per cent of issuance value, subject to tax at a 16 per cent on an accrual basis. Amounts are converted to an annualized value at a 5 per cent discount rate.
1 Professor of Business Economics, J. L. Rotman School of Management, University of Toronto.
2 Lalit Aggarwal and Jack Mintz, â€œIncome Trusts and Shareholder Taxation: Getting it Rightâ€, Canadian Tax Journal, 52(3), 792-818.
3 Scotia Capital, Business Trust Bulletin, October 11, 2006.
4 Most of the data that I use to base my calculations are taken from Canada, â€œTax and Other Issues Related to Publicly Listed Flow-through Entitiesâ€, Consultation Paper, Finance Canada, September 2005. I have attempted to update values to 2006, including the incorporation of tax changes.
5 This calculation assumes that firms do not benefit from a lower cost of capital arising from trust conversions. It is unlikely all the tax reduction would accrue to investors so that inclusion of personal tax gains on pension income would be overstated. However, if businesses benefit from a lower cost of capital, additional corporate and personal tax revenues would be paid reflecting greater investment.