Accounting news roundup

Accounting Standards

Income trust standards (or lack thereof) and risk

So everyone and their grandpa is still upset about the recent change to income trusts introduced by the Canadian federal government. The change was, of course, to implement a tax on trust income similar to corporate income tax.

The outrage epicentre is Bay Street, Canada’s version of Wall Street, in the heart of the financial district in downtown Toronto. But in the radiating waves of anger from that focal point, senior citizens seem to be most upset. Could that be because they are more likely to be Conservative party supporters, the party that pledged no trust tax in the last election? Possibly, but it also has to do with retirement savings and poor investment advice.

The most apoplectic are the ones who concentrated their investments in the risky vehicles.

This violates the sacred first rule of investing – diversify your holdings. Unfortunately, it seems that the only diversification many people paid attention to was in the underlying nature of the trust business – i.e. natural resources (oil and gas trusts are huge). It didn’t occur to anyone to diversify amongst vehicles – some trusts, some equities, some bonds, some derivatives, etc.

The risky nature of trusts is related to the relative lack of policing by either securities regulators, or accounting standards setters. Distributable cash is a key metric for trusts, because they are by design supposed to distribute nearly all cash generated, and one that has to this point been ignored by both parties above.

The accounting standards body in Canada, the AcSB, has no guidance on trust disclosure, and the national securities regulator, the CSA, has only suggestions as to disclosing that distributable cash is estimated based on reasonable assumptions. As Al Rosen, a popular Canadian accountant and frequent contributor to various business publications, points out: “Is any company about to admit that their predictions of distributable cash are completely unrealistic?”

Trusts need more attention from accounting standards setters and securities regulators, that much is certain. But investors also need to be aware that diversification should be done across investment vehicles, as well as industries. Both carry different types of risks.


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.


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.