This article was first published on the Globe and Mail website under the title "Income trusts are neither unfair nor socially harmful" on November 8, 2006.
Many have welcomed Finance Minister Jim Flaherty's decision to tax income trust distributions on the basis that it closes a loophole that was both unfair and socially harmful.
The income trust was said to be unfair, in that it permitted public companies to get away without paying their fair share of taxes, meaning that individual taxpayers had to shoulder more of the tax burden. As for the harm, it resided, supposedly, in the fact that income trusts commit to distributing much of their net cash flow to investors, rather than reinvesting it. This, so the story goes, means less investment in innovation. In fact, there is less to both of these objections to the income trust than at first appears.
Consider first the fairness argument. Taxes imposed on corporations and trusts may gratify a certain popular urge, but it is important to remember that corporations and trusts are conduits ó the burden of any tax imposed on a corporation or a trust is ultimately borne by real people. In practice, for example, corporate taxes are borne by consumers in the form of higher prices, labour in the form of lower wages, or shareholders in the form of reduced dividends or capital gains. No one should be under the illusion that corporate taxes are a tax on wealthy executives.
Who are the real people who will bear the new tax on trust distributions? Recall that the "problems" with the income trust structure are that it permits:
foreign investors to pay less tax on their investments in Canadian businesses than they would if they instead held shares in a Canadian corporation;
owners of RRSPs and beneficiaries of pension plans to defer the payment of any tax on the income from these businesses until they retire and receive distributions from their plans.
The tax on trust distributions is a way of eliminating both of these advantages: It is, in other words, a tax on non-resident investors and a tax on RRSPs and pension plans.
Few Canadians will complain about a new tax on foreign investors ó although they hold only 22 per cent of income trust units, and if they were the main target, it might have been more straightforward to increase the existing withholding tax on income trust distributions to non-resident investors, to the extent possible within our tax treaties.
But what about limiting tax deferral by RRSPs and pension plans? By limiting tax deferral, the government closes a revenue gap that it might otherwise have had to make up by increasing (or, in the current environment, not reducing) personal income taxes. But today's taxpayers and tomorrow's retirees are largely the same people, so depriving retirement savers of a tax advantage as a way of reducing personal income taxes is taking from Peter to pay ... Peter. One may also wonder whether it is good public policy in a country with our demographics. In any event, it is not about tax fairness.
Consider next the argument that because income trusts commit to distributing cash to investors, there will be less investment in innovation. The problem with this argument is that a commitment to distribute cash to investors does not preclude a business that is organized as an income trust from making investments in innovation or any other long-term investments. It simply requires management to return to the capital market to raise the funds to do so. Rather than being able to take for granted that they can hang on to investors' profits, and thereby amass large corporate treasuries for discretionary projects, the managers of an income trust must persuade investors to entrust more money to them. They must persuade the market that the project is worthwhile. The income trust, in other words, is an antidote to empire-building.
Is it likely the investors in income trusts will reinvest their distributions, or will they fritter them away on consumer goods? If the latter were probable, perhaps this might provide a reason to fear an "income trust economy." But remember that a large proportion of income trust units are held in RRSPs and pension plans. The distributions received by investors such as these are invariably reinvested somewhere. It is just that with cash in hand, the investor has a choice whether to reinvest his or her profits in the same income trust or elsewhere. The managers of income trusts, in other words, must compete with one another for investors' money. How harmful is that?
Because of the other measures accompanying the new trust tax, and the capacity which the trust tax will preserve for the government to reduce personal income taxes, taxpayers will enjoy some tax relief today. This will come at a cost: slower growth in their retirement savings and less accountability of managers to investors. Whether the tradeoff is worth it is a question about which reasonable people can differ. But it is not clear that the tax can be justified by any necessity to ensure fairness or investment in innovation.
