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
Unitholders
Trust Units Cash Distributions

Trust
Lease Lease payments

Operating Corporation

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

Unitholders
Cash Distributions (income and return of capital)

Trust

Royalty Payments

Operating Corporation

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)
Unitholders

Trust Units

Cash Distributions (income and return of capital)

Trust
Equity Debt Royalty interest Lease Interest/ Royalty/ Lease payments, Dividends and Return of Capital

Corporation

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

Business Income Trust

(Second Generation)
Unitholders

Income Trust

Operating Trust

General Partner (Corporation)

Limited Partnership
Source: RBC Capital Markets

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)

Business Income Trust

(Third Generation)
Unitholders

Income Trust
General Partner (Corporation)

Foreign property limit repealed in the 2005 budget Operating trust not required

Limited Partnership

Source: RBC Capital Markets

Recent Growth
200 Energy trusts Business trusts REITs 160 Limited partnerships

120

80

40

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

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)

Types of Income Trusts

Trusts Energy (Oil and Gas royalty) REITs Business Income Trusts - Power & Pipelines - Industrial Products - Media, Telecom Entertainment - Consumer Products - Energy Services - Transportation / Storage - Marketing /Distributions - Professional Services - Food Products - Restaurents (royalty paying) 36 25 173 22 31 17 33 14 18 5 9 16 8 234 ($ million) 79,493 21,781 92,531 19,690 17,447 14,805 10,103 9,420 8,934 5,758 2,768 2,559 1,047 193,805 (% ) 41.0% 11.2% 47.7% 10.2% 9.0% 7.6% 5.2% 4.9% 4.6% 3.0% 1.4% 1.3% 0.5% 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, taxexempt (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. taxexempts) 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?