Ottawa Stuns Business With Income Trust Tax Plan Reversal

Federal Finance Minister Jim Flaherty shocked Bay St. and business on Tuesday, waiting for the markets to close before issuing a bombshell announcement. The Conservatives are going to tax income trusts, a change that will have a ricochet effect on the markets.

Many industry giants have made the move to convert their corporations to income trusts because they can then pay dividends directly to investors while avoiding huge tax payouts to the government.

Under the current scheme, those holding investments in large companies receive the money and pay the levy on that income. And because they’re individuals who make smaller profits, the tax revenue shrinks.

At the same time, the companies are able to hang to keep more bucks on their end without handing anything over to the waiting taxman.

Flaherty claims Ottawa’s coffers just can’t withstand losing that much revenue as more and more businesses jump on the loophole bandwagon. So he’s erecting a giant stop sign before the financial highway gets any busier.

“Left unchecked, such corporate decisions would result in billions of dollars in less revenue for the federal government to invest in the priorities of Canadians,” he contends.

The proposed rules would apply a new tax on the money distributed to shareholders by newly formed income trusts, and would tax “certain distributions” of income by trusts at corporate rates.

The rules are expected to apply to any publicly traded income trust other than one that holds passive real-estate investments.

The changes will kick in for companies that have converted after October and the taxes will be due in 2007. Those who’ve already made the move will have until 2011 to set their financial houses straight before kicking the full amounts back into Ottawa’s kitty.

In exchange, the government will lower corporate tax rates to 18.5 percent by the latter date to help alleviate some of the shock.

That places the recent income trust announcements by both BCE and Telus in jeopardy, a fact that didn’t escape Flaherty’s attention.

“BCE and Telus will not be able to become income trusts and have the tax benefits that are currently available,” he responds when pressed about the two major entities. “Does that make it clear?”

Crystal clear, according to Bell Canada, which confirmed Wednesday it’s rethinking its conversion strategy.

“The Minister’s announcement clearly has a significant impact on our proposed conversion and the immediate benefits such a conversion would have delivered to our shareholders,” BCE C.E.O. Michael Sabia notes in a statement. “We will assess the proposed changes over the coming days and evaluate our options.”

Telus is expressing similar reservations. ” As a result of the announcement by the Federal Minister of Finance, there can be no assurance at this time that Telus will proceed with its proposed income trust conversion,” the company admits in a statement.

The move breaks a promise the Tories made during the election, a vow that won them the backing of Bay St.

But Flaherty insists it can’t wait. “It is a trend that has caused me growing concern. If corporations don’t pay their share of taxes, this tax burden will shift onto the shoulders of hardworking individuals and their families.”

Business execs were stunned by the sudden shift, and expressed outrage and worry about what the moves could mean for their bottom lines.

“Companies like ours have made a long-term strategic change because of what they said,” complains William Holland of  mutual fund company CI Financial Income Fund. “We tried for three years to (convert into an income trust) and they changed the rules three times. And then, finally, we converted when they said they’d leave them alone.”

He calls the change “incredibly irresponsible” and claims the actions are like that of a “third world country.”

The move could have a major effect on the savings and investments of millions of Canadians.

This country currently has about 250 trusts – worth about $200 billion – in real estate, oil and gas, telecom, industrial, food processing and manufacturing sectors. They’ve become a popular investment vehicle but can be risky investments if business conditions deteriorate and companies are forced to cut payments.

Or, it would seem, if governments suddenly change their minds.

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Income Trust Primer

What is a trust?: A type of corporate security similar to a share in a company.

Difference: Unlike companies who pay dividends to shareholders and pay corporate taxes, corporations who convert to trusts pay most of their cash flows to investors in monthly distributions.

Tax impact: Trusts pay little or no corporate taxes because their cash flows go to investors.

Investors: Canadians who own trust units will pay taxes on any gains made outside tax-protected RRSPs or other investments.

Popularity: Income trusts started in the oilpatch in the mid-1980s and have grown in popularity in recent years as they face a lower tax burden than regular corporations.

Extent: Canada has about 250 trusts – worth about $200 billion – in real estate, oil and gas, telecom, industrial, food processing and manufacturing sectors.

New rules: Ottawa would apply a new tax on the money distributed to unitholders by newly formed income trusts.

Transition: Existing income trusts would be given a four-year transition period, ending in 2011, that would allow them to adjust to the new rules.

Further: Corporate income taxes would be cut by 2011 to remove some of the market incentives to forming income trusts.

Quote: “If corporations don’t pay their fair share of taxes, this tax burden will shift onto the shoulders of hard working individuals and their families. This is simply not fair.”  Finance Minister Jim Flaherty at an Ottawa news conference.

End Quote: “They shouldn’t make any changes. They said they were going to leave income trusts alone. Well, they’re not leaving them alone. That’s the problem.”  William Holland, chief executive of mutual fund company CI Financial Income Fund, which converted into a trust this spring.