If Jim Flaherty's reforms to taxation of income trusts are passed by Parliament, as seems likely, the affected firms face choices. It is too early to tell precisely what the predominant response will be, of course, but one thing is nearly certain: The high-distribution party will come to a dramatic end in 2011. The new taxation measures make such distributions considerably less attractive.
A high-distribution policy will no longer be optimal for income trusts beginning in 2011 because all distributions will have tax imposed at a combined federal-provincial rate of 31.5%. All income that is retained by the operating company and not paid to the trust in the form of interest will also be subject to tax -- in this case, the regular corporate tax -- at a combined federal-provincial rate of 31.5%.
As a result, there will no longer be a tax advantage associated with distributing income in the form of interest to be taxed in the hands of unitholders of the income trust. Indeed, distributions made to unitholders of income trusts will also be subject to taxation as if the distributions were dividends. The net result will be that all distributions to unitholders of trusts will walk like, talk like, and be taxed like dividends.
Why should treating income trust distributions like dividends encourage income trusts to cut their distributions? As a start, one can simply observe that very few corporations on the TSX have dividend rates that rival the distribution rates of most income trusts. A recent search turned up only five TSX-traded companies (out of more than 1,000) whose common shares had a dividend yield of 8% or higher -- less than one-half of 1% of the common-equity issues traded on the exchange. Only 11 of 238 preferred shares had yields of 8% or higher -- less than 5% of such equities. This compares with the fact that considerably more than half (296 of 464) of the income trusts on the TSX have yields of 8% or more.
This stark difference is accounted for primarily by the impact of taxes. When corporations retain and reinvest earnings, they pay taxes only at the corporate rate, currently around 34%. If corporations distribute earnings as dividends, approximately another 14% of taxes are paid by dividend recipients (assuming the recipients are taxable Canadian residents with income at the highest marginal tax rate).
If, on the other hand, corporations retain and reinvest their earnings, shareholders are free to determine the timing of the realization of accumulated capital gains (or losses) and thus can exert some control over their tax bills. Dividend distributions reduce the control of individual shareholders and, consequently, have two undesirable tax effects for shareholders: Dividends constrain the ability of shareholders to control the realization of income by timing capital gains and losses and dividends lessen the deferral advantage of earnings being reinvested in the corporation at a rate of tax lower than that available to shareholders. For both reasons, so long as reasonable opportunities are available to profitably reinvest income, shareholders prefer companies to do so. For the most part, companies oblige their shareholders by having relatively low dividend policies.
There are two obvious possibilities for how the high-distribution policies will end in 2011. The first alternative is that income trusts will remain in their current structures but simply reduce (or eliminate) their distributions. Under this first alternative, existing income trusts will continue to be organized as income trusts but will behave more like corporations in that their distribution policies will adopt dividend policies similar to those of comparable publicly traded corporations. The second alternative will be for income trusts to simply convert (or revert) to conventional publicly traded corporations.
The difference in the two alternatives mostly has to do with corporate governance. Income trusts are not directly subject to the same rules as corporations under federal or provincial corporate law. It is not obvious that the more flexible terms under which income trusts have been established are more or less desirable than the mandatory provisions imposed by corporate law. One incidental benefit of the change in tax rules in 2011 is that it should be possible to isolate whether more flexibility in corporate governance is rewarded by the market.