Income trusts in Canada to be taxed after all

The Canadian Federal government announced on Halloween that income trusts will now be subject to income tax of 34% in line with corporate income taxes in the country. You might remember that many corporations were converting or considering conversion to income trusts to take advantage of the flow-through nature of the structure recently.

I argued that the tax corporations would save upon conversion could be considered unfair tax anyway since it was entirely consisting of double tax. The government seemed to disagree with me or not care, and made the announcement to the apparent chagrin of many people, which is strange considering how much heat the government was taking to close the loophole and maintain their base.

What I was thinking today is that the government could end up enlarging their base with this move. They wanted to take away the incentive for companies to convert, and they’ve done that. Bell Canada is reconsidering the move to income trust and probably won’t do it after all. Telus may reverse plans to convert. So things will stay the same on that front, only now income trusts that were always income trusts (ie. mutual funds) will also be taxed.

This is probably going to only increase the already-embarrassing federal surplus in the country, which was recently in the news because it was much higher than forecasted.

I’m not sure this is the most elegant solution to the problem, but it’s a solution when one was needed, and for that the government should be applauded. Perhaps introducing some rules that made income trusts even more restricted would’ve been a way to discourage corporate conversions while not introducing a whole new tax on trusts. After all, there are still some pretty fundamental differences between a mutual fund and an operating company.


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.