Flow-Through Entities And Taxation

Income Trust Tax Consultation

Consultation Background

In September, 2005, the Canadian federal government's Department Of Finance initiated its public consultation on the topic of "Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships)" with the release of a consultation paper. The paper raises a number of questions for consideration on the above topic. Submissions to the consultation by any interested parties can be e-mailed to trusts-fiducies@fin.gc.ca before the closing date, 31 Dec 2005. With author permission, the Department of Finance offers to post submissions on its web site. Questions concerning the consultation can be sent to consltcomm@fin.gc.ca .

Procedural Stonewall

Despite the Department referring to its consultation as "open and transparent", it is important to note that submissions will not be posted until after the consultation closes (i.e., not until 2006), regardless of how early they are received.

This is a very disturbing policy for a variety of reasons, including:

Submissions being prepared may waste effort `re-creating the wheel' of other submissions;
Submissions may not have a chance to respond to and `de-bunk' specious arguments in other submissions;
It leaves very little time for the public to read, absorb and react to the full range of posted submissions before early January 2006, when the Finance Minister has indicated he will "act promptly", despite an imminent federal election.

As it stands then, interested parties must for now scour the media, web, etc., for (often preliminary) nuggets of content on this subject that are scattered here and there.

A Draft Submission

In this context, I am placing a draft version of my submission to the consultation here. In this way the ideas might be spread around earlier, and generate comments and criticisms which may improve the final submission. To that end, here is my

Draft Submission.

You can send comments on this document to the e-mail address below. If there is interest, I might post some comments here.

Note: Due to the circumstances described next, it was not possible to make this submission to the consultation. The draft will have to evolve and remain here.

Finance's Announcement Of Nov 23, 2005

On Nov 23, 2005, the Minister Of Finance announced that: the public consultation would be closed immediately; no changes would be made to the taxation of flow-through entities; the resumption of Departmental advance tax rulings on trust conversion; and an attempt to reduce dividend taxes for "eligible" large-corporation dividends. Existing submissions to the now-closed consultation will be posted on the Department web site when they have been processed. Proposals in preparation but not yet submitted are presumably out of luck.

Some general comments and opinions related to this:

No Changes to FTE Taxation: This concurs with my draft submission's Component 1, and is the right decision. One suspects, however, that it was made at this time for political reasons as much as any other. To that extent, this issue might rear its head again in the future, although probably not in the near term (once bitten, twice shy).
Advance Ruling Resumption: Absolutely necessary. The suspension of these rulings in the first place was tantamount to a wildcat strike: a government function paid for by taxpayers was not being performed with no basis in legislation.
Dividend Tax Reduction: The announced "enhanced" gross-up (45% instead of 25%) and dividend tax credit factor (19% instead of 2/15 (about 13.3%)) applicable for dividends that have not been taxed at the small business rate, reduces duplicate taxation in this case, while maintaining "integration" for small business dividends (where the new proposal is not applied). While any tax reduction is, of course, welcome, the one announced falls into the "clumsy" camp discussed in Component 3 of my draft submission, specifically:
1. It does absolutely nothing to eliminate double taxation of dividends earned within tax-deferred plans (e.g., pension, RSP). Such dividends result from earnings that have been taxed once at the corporate level, and are then fully taxed again (with no tax credit) when withdrawn from the plan.
2. It adds new layers of complexity as it introduces the concept of "eligible dividends", requires tracking both types of dividends along their avenue of flow, and splits the gross-up and tax credit procedure into separate cases.
3. The elimination of double taxation of dividends (within taxable plans) is only approximately true. E.g., the 45% gross-up rate assumes a corporate tax rate of about 31%, while the 19% tax credit factor corresponds to corporate taxes at about 29% (using the same simple model that generates 2/15 now). Not only are these two notional rates different from each other, but they differ from actual rates at present, and potentially in the future.
4. This "button-twisting and special-casing" modification to the flawed existing system is not particularly transparent and will require further button-twisting maintenance as tax rates change over the course of time.
5. All of these, and potentially other, drawbacks are entirely unnecessary results of insisting that corporate profits be taxed first at the corporate level and second at the investor level (both at variable rates). They could be completely eliminated by treating corporate dividends in a flow-through fashion as proposed in Component 3 of my draft submission. This would provide true, simple and transparent neutrality.
Unaddressed Distortions: Finally, note that the announcement only attempts to address double taxation of dividends. A significant remaining distortion in the Canadian tax system is the duplicate taxation of capital gains on equity securities. This problem is completely ignored. See Components 4 and 5 of my draft submission for an outline of the fair way to address this problem.

All of these objections taken together might lead a skeptic to regard the announced policy as hastily proposed, conceptually pedestrian, inefficient and inadequate in scope.

Disclaimer

The ideas offered and opinions expressed here and in the above draft submission are my own, and have been developed independently. I do not speak for, and am not funded by, any group, organization, etc.

You can contact Frank by e-mail.

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