The other upside to income trusts

Bell logoI wrote a post about BCE converting from a corporation to an income trust a couple days ago that set off a veritable firestorm of comments from a few readers. It quickly became the most commented on post here, which is pretty cool.

So with that in mind I jumped at the chance to blog about this article in the Globe and Mail, which talks about the other advantage of income trust conversion:

They function as a kind of a leash on executives bent on sacrificing upfront, predictable profits in their core business in favour of empire-building or diversification. Because trusts pay out the bulk of their cash to unitholders, they are forced, in essence, to ask permission from investors every time they want to raise money for a large acquisition.

BCE has a long history of making big acquisitions that have led to huge losses. The temptation of management to reinvest profits from their core business into diversified ventures has repeatedly destroyed millions (billions?) in shareholder value.

Since the conglomerate enterprise was established during the early 1980s, BCE has got into and out of businesses as diverse as pipelines, packaging, commercial property, a trust company and a television network, frequently generating losses in the hundreds of millions of dollars on its investment miscues.

This is a common problem it seems with large corporations. They diversify to manage risk, ignoring the fact that investors already diversify their portfolios to manage the same risk. The only time it makes sense for a corporation to invest profits into a new venture is when it is so closely related to their core business that they can generate higher returns than an individual (or institutional) investor could by taking their share and investing it in the venture themselves.

This has very rarely been the situation for BCE’s investments, and that’s another reason, and potentially more lucrative than the tax savings, why income trust conversion is a good move for BCE shareholders.


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.