Income trust tax loophole gaining popularity

Income trusts have dominated business headlines in Canada for the past couple days, ever since one of the oldest corporations in the country announced they were converting to save hundreds of millions in corporate taxes.

Income trusts eliminate the double taxation in Canada on business income above the small business limit ($300,000 in 2006). Up to the limit, there is near-perfect integration, meaning there is no difference between earning income in a corporation or personally. (Trust income is like personally-earned for all intents and purposes.)

Integration in Canada is achieved below the noted threshold via two mechanisms. One on the corporate side and one on the shareholder side. Corporations are taxed on their income, and income up to the limit is eligible for the “small business deduction”, basically a reduced rate. Shareholders receive corporate income via dividends, which are grossed up by 25%, taxed at the marginal rate, and then the dividend tax credit eliminates the gross-up.

It’s been a couple years nearly since my last tax course in school, so I don’t remember the specifics, but somehow, it works. But income above the limit is not eligible for the reduced rate, and the difference is double tax. So as business journalists are shrill with rage that BCE (Bell Canada Enterprises) and other companies are robbing the state of needed tax dollars, those in the know realize that it was unfair tax to begin with.

As well, one of the fundamental aims of any tax system is to avoid creating situations where tax influences decisions. Clearly, that is happening here.

The government still needs money for programs, however, and ordinary Canadians have good reason to be concerned about the slimming of the corporate tax base. But I would argue that instead of drastic measures that would seek to restore the double tax in some form, we should consider other options, such as increasing rates on personal tax.

If you’re frequent reader of my ramblings, you know my favourite option is jacking up the value-added GST to about 25% and eliminating all other taxes. But this isn’t tax utopia, and that isn’t happening any time soon.

The problem is misinformation, however, and a lack of understanding about the nature of the tax being “lost”. Here’s a blog that seeks to quantify the lost revenue the conversion of BCE will cause. It’s a useful endeavour, and is generally done correctly, but completely ignores the most important part about the revenue: it was inefficient, unfair, and decision-influencing (which is bad) to begin with.

20 replies on “Income trust tax loophole gaining popularity”

  1. You said:

    “This should hardly the department of finance model suggests that the conversion to trusts reduces the effective tax rate on corporate profits from 42.85% to 18.12%. And this speaks to the general thrust of our argument. The increase in revenue flowing to investors has been achieved via regulatory arbitrage not one new product was brought to market, nor was productivity increased, nor was one job created to “create” this “value” for shareholders. And this gives the lie to all those supply side arguments that taxing capital is inefficient. What is inefficient is providing tax giveaways to shareholders of companies that produce nothing save a drag on the revenue of the state and a termination stub to unionized employees. We suppose we should thank our teachers for math. We will let the Pencils do the simple math to determine whether we or they met the substantial 66% cut-off.”

    First of all, this is not about capital tax. This is about income tax. Very different. Taxing capital is inefficient because it discourages investment – in revenue generating equipment, as well as employees.

    My point about efficiency is that the reduction you’ve noted above in the effective tax rate on corporate/trust/business profits is inefficient no matter what rate it is, because of double taxation. The government is double-dipping, and they stand to lose that opportunity. (Ignoring the fact that they created the opportunity in the first place.)

    I guess another point I could make is this: If you had an opportunity to legally pay less tax, I’m certain you would take advantage of it. It is irrational not to.

    Enjoying the discussion we’re having,
    Neil

  2. Once again we have to down our good read for those unwilling to follow a hyper link. Well here it is the Department of Finance’s simplified tax models. All of our structural assumptions were taken from there. You miss the point. There is no correlation accross the high income OECD between effective corporate tax rates and the rate of investment nor on the more blunt measure of real GDP growth. The correlation just does not exist. So your whole argument about incentives to invest (on the part of Capital is bogus at the margin).
    What is ineffecient is rewarding shareholders who have fialed to create anything. Of course it is rational from the POV of capital to get more for nothing but it is irrational from the POV of soiciety as whole. The only way to defeat this is to show that such a reduction in tax will increase overall social welfare. Good luck modelling that. But if you must, try a stock out of the box GE model with unwordly assumptions and we bet you get close to there.

    Goodwin

  3. And by the by did you ever consider that income tax discourages work. So according to your understanding all taxes are bad?
    To be frank we have never understood the double taxation argument. CIT is a tax on an entity which is legally considered and individual hence it is a tax on income not capital. That is why the tax code provides generous right off schedules for capital (double meaning intended). As such there is no such thing as double taxation if by what you mean is tax on a cost of running a corp.

  4. I’ve addressed the shortcoming of GG’s analysis of the tax impact of the BCE conversion on his post. Essentially, he forgets to include deferred taxes in his calculations.

    The issue GG with “double taxation” is that presently the government first taxes corporate income and then taxes it again as it is distributed to shareholders. The dividend tax credit partly addresses this issue but effective tax rates vary widely across income levels of the recipients as well as the form of the income that is distributed (i.e., dividends, capital gains or interest). Already, we have corporations making funding decisions to arbitrage among these different forms of financing.

    The income trust option is just another twist on this. The cost of capital is reduced because the effective tax rate is reduced. It is ludicrous, however, to suggest that lower tax rates on capital have no impact on capital formation at the margin. That is basic economics 101. You might want to review that, or even Das Kapital for that matter.

  5. We are well aware of what a school boys intro text to economics has to say about tax rates at the margin. We are more interested in reality then the fantasies of econ 101. In the real world tax increases decreases certainly effect such things as corporate structure tax avoidance and the like what they do not however do very well at all is alter the path of investment which from a macroeconomic point of view is all that matters. Given the corporate trax cuts over the past years why has investment been de accelerating and not accelerating? For that you will need Marx or perhaps veblen but not chicago or mit.
    This is not an ideological argument it is an empirical problem which cuts to the bone of public policy and taxation. Trusts encourage tax avoidance and stripping out of funds that could be used for investing in productivity enhancing activities.
    As to your double taxation argument we have posted the following on this topic:
    Trust Calculation Debate Part 4: An Issue of Double Taxation or a Boondoggle?
    http://canadianobserver.wordpress.com/2006/10/13/trust-calculation-debate-part-4-an-issue-of-double-taxation-or-a-boondoggle/

  6. Given the corporate trax cuts over the past years why has investment been de accelerating and not accelerating?

    Nothing like making things up. Business investment is strongly correlated to cash flows. The statistics simply do not support your assertion.

  7. Yeah I have to agree with Steve (since he’s supporting my position)… You do seem to be pulling a lot of stuff out of thin air. You can’t win this argument by logic, because the logic supports BCE’s move. If you just want the cash, say that. But it won’t make the system any fairer. Let’s just agree that if the Feds want to close the loophole, they can do so, and if they don’t, feel free to rail against them for that. But you can’t blame BCE for saving themselves money.

  8. We never argued it was not a rational move from BCE’s POV. All we argued was that the public was getting stiffed for hundreds of milions of dollars. And we further argued that it was a great example of where lower taxes meant bigger private gain without producing positive social externalities.
    We will get back to you on the correlation between tax cuts and the rate of growth in investment and GDP growth. Stats can has very nice data going back to 74 which will give us three cycles to run the correlations on. Check our blog the results should be up in the next week or so.

  9. On a slightly unrelated note – to the above lively conversation – I wonder what effect hiking GST to 25% would have on making the black market explode? ;)

  10. Nice looking blog, D. Can’t say as I’ve ever been a card-carrying member of any political party (and the Green Party would probably be first on my list if I was), but I’m a little miffed that Harper would so blatantly break a such a clear promise, forced though his hand was over this income trust thing.

  11. I’ve taken a quick look at your postings, which are very interesting. Lots of material and ideas! Congrats on being so focused!

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