Document revision: v0.26
Topic:
Preliminary draft submission to Department of Finance public
consultation on "Tax and Other Issues Related to Publicly Listed
Flow-Through Entities (Income Trusts and Limited Partnerships)".
Wrapper: http://home.cc.umanitoba.ca/~molzahn/flowthru.html
This draft: http://home.cc.umanitoba.ca/~molzahn/fte_draft.html
Author: Frank Molzahn
E-mail: molzahn@cc.umanitoba.ca
INTRODUCTION
============
This submission outlines a logical plan for addressing the problems
in the tax system which have been hi-lighted by the recent
popularity of income trusts. The five components of this plan form
a coherent whole, and should be read in that context, not isolated
from one another. The basic principles governing the plan are:
fairness, creating a level playing field, avoiding double taxation,
transparency and simplicity (conceptual and where possible
implementational).
The Department of Finance in its Consultation Paper presents five
"Questions for Consideration" concerning flow-through entities
(FTEs). While these questions originally motivated this submission,
it is essential not to focus exclusively on FTEs and artificially
detach them from all other relevant factors and then impute them
with unrestricted significance. Instead, FTEs are viewed here
within the wider scope of Canada's taxation system, and the changes
believed necessary for it are presented. Thus, this discussion is
not organized tightly around the five "Questions for Consideration",
but might well be read entirely as a response to Question 5 about
policy approaches.
The presentation here is a brief outline only, stating the plan's
components, and their main motivations and consequences. While the
consultation is on FTEs in general, we usually refer here to income
trusts specifically, for the sake of definiteness. Indeed, income
trusts, as opposed to limited partnerships, form by far the greater
portion of FTEs, and many of the issues are similar for the two.
The taxable income flowing through an income trust can take the form
of ordinary or interest income, dividends, capital gains and return
of capital, and foreign income. For simplicity, this discussion
will ignore foreign income which, again, composes only a small
portion of the income distributed by trusts in practice.
A LOGICAL PLAN
==============
Income trusts act somewhat like a conduit, moving taxable income
unaltered from one area (business entities) to another (investors).
As such, income trusts are relatively simple structures and do not
contain any undesirable distortions or inequities in themselves.
They can, however, bring into evidence any such problems which
already exist within the tax system, and there are many.
Component 1: Do not alter in any way the current tax treatment of
----------- income trusts.
- As noted above, income trusts are not inherently flawed. They are
therefore best left as is. (I.e., fix what is broken, not what
isn't). To the extent that they magnify problems in the tax
system, it is best to make systemic changes that deal directly
with the root cause of any such problem. Such necessary changes
are given in the Components which follow.
- Corollary: Do not "grandfather" existing income trusts and then
impose different punitive tax rules on any new income trusts which
may arise. This would be highly discriminatory, over-complex and
cause significant legal problems. E.g., what happens when a
grandfathered trust merges with a new one?
- This Component provides status quo certainty to capital market
participants who have made decisions based on existing rules
about trusts that could and should not have reasonably been
expected to change.
- Income trusts are not the only kind of legal trusts, in fact they
originated when businesses adopted a pre-existing trust structure.
It would be arbitrary, discriminatory and problematic to change
the rules only for certain kinds of trusts (i.e., income).
Likewise, it would be unfair to saddle all trusts with new
legislation intended only to "fix" income trusts.
Component 2: Corporate and individual tax rates should be brought
----------- into alignment.
- This could either be done literally, by having the same tax rate
structure apply to both. Or, it could be done in an average
sense, so that the average corporate income incurs the same
overall tax rate as an average individual (both averages being
appropriately weighted).
- The primary purpose of this component is to eliminate the existing
distortion between tax rates for corporations and investors which
income trusts bring to the fore by flowing taxable income between
them.
- This Component aligns with the concept of a corporation being an
abstract legal entity having the same rights as an individual.
- The details (brackets, rates, etc.) of the common tax structure
would, of course, be set to provide government with adequate tax
revenue for its expenditures, and could be adjusted over time as
necessary for that purpose, to promote competitiveness, etc.
Component 3: Treat corporate dividends as a flow-through quantity:
----------- make them a full deduction from corporate income that is
taxed only at the level of the investor receiving the
dividend. At the same time, the tax rate on the dividend
should be the same as for ordinary income.
To clarify, this means corporations can pay out larger dividends
because they pay no tax on that part of their profits. However,
the investor is taxed at the full rate on the dividend (with no
dividend tax credit).
- The two parts of this component put corporate dividends on an
equal footing with ordinary income, whether received via a trust
or not.
- This Component transparently eliminates double taxation of
dividends. It does so under all circumstances.
- Investors would receive more pre-tax income, but have no tax
credit to apply. Their after-tax dividend income would be at
least as much as it currently is (depending on the corporate tax
rate) due to the potential elimination of duplicate taxation.
- This is a great simplification from the current confusing system
whereby corporate income is taxed once at the entity level and
again at the investor level using a flawed, inflexible scheme of
dividend gross-ups and tax credits. This so-called "integration"
scheme is designed to make the total taxes paid by small
businesses roughly independent of whether or not they are
incorporated. It does this by hard-wiring the 20% small business
tax rate into its gross-up (25%) and tax credit (13.33%) factors
(specifically, 5/4 x 2/15 x 3/2 = 20%). This scheme creates an
insufficient tax credit (less than half the fair amount) when
applied to large-corporation dividends which have already been
taxed at about 35%. The net result: duplicate or excess taxation.
Moreover, any attempt to replace this scheme with a similarly
clumsy one will inevitably fail for some corporate tax rates, or
lead to excessive complexities. By contrast, the flow-through
treatment proposed in Component 3 universally eliminates duplicate
taxation simply and transparently.
- For income trusts, this means dividend income and ordinary income
can be combined into a single payment type (because they are
taxed at the same rate). Indeed, they truly become the same
thing due to the common flow-through property.
- One might question why dividends should be taxed in the hands of
investors rather than corporations: In view of Component 2,
wouldn't the overall tax paid be about the same? The answer is
no, it wouldn't always, because of tax-deferred plans such as
pension funds, RSPs, RIFs etc. Funds withdrawn from tax-deferred
plans are fully taxed as ordinary income; if those funds
originated from dividend payments out of already-taxed corporate
profits this would be double taxation. Therefore Component 3 has
the benefit of putting dividend income on an equal footing with
tax-deferred income while maintaining single-taxation of the
income stream.
- In Section 7, "Potential Policy Approaches", of its Consultation
Paper the Department of Finance raises the possibility of taxing
FTEs in a manner similar to corporations, yet curiously omits to
mention the complementary approach proposed here of treating
corporations more like FTEs.
Component 4: Net capital gains on equity securities (e.g.,
----------- corporate shares or FTE units) must be tax-exempt
within taxable accounts.
This may at first sight be surprising, but it is an inevitable
consequence of eliminating double taxation. Consider two arguments,
in the context of Components 2 and 3, which each verify this:
(1) If a corporation earns $1 and decides not to pay it as a
dividend, then it pays tax on that $1. The amount remaining
after-tax becomes an asset on the balance sheet and is reflected in
the share price. Alternatively, if the corporation does pay the $1
out as a dividend, tax is paid instead by the investor and the share
price drops to reflect the dividend payment (the stock goes
ex-dividend). The different share prices in these two scenarios
create different capital gains if the investor sells the stock.
Clearly, since in each case the $1 of income has already been taxed,
the investor should not also be taxed on the extra capital gain
arising from the lack of a dividend payment. The total tax paid
should be independent of the corporate decision to pay a dividend or
not. Thus, the capital gain must be tax-free.
(2) More generally, capital gains, i.e., differences in share prices
over time, are driven by two main factors: earnings and investor
sentiment. Corporate earnings are taxed as such, and only net
after-tax earnings affect share prices. Thus taxing the capital
gains that occur when share prices increase due to net earnings
flowing into a corporation is unjustifiable double taxation. As for
the sentiment factor, it rises and falls over the course of time,
but always remains bounded. There is no sound reason to tax
sentiment-driven capital gains arising during optimistic times, only
to have them erased by capital losses incurred during pessimistic
markets.
- Implementation of this component would:
* eliminate an avenue of significant double taxation,
* encourage investment,
* greatly simplify non-registered share and trust investment: it
ends the need for complex tracking of capital gains and losses,
and their attendant arcana.
- For income trusts, this means capital gains would become a
tax-free component of the distribution stream (similar to return
of capital, but with no limit).
- Historically, capital gains were originally tax exempt. Later
they became taxed by adding them into income with an inclusion
rate of 75%, which was later changed to 2/3 and finally to the
current 50%. All of these latter rates are arbitrary and based
upon various exigencies of the day rather than any fairness
principle. The arguments outlined above show that 0% is the right
inclusion rate based upon the principle of no duplicate taxation.
- It is beyond the scope of this document to offer an opinion
concerning the taxation of capital gains arising from capital
property that is not an equity security.
Component 5. Net capital gains on equity securities held in tax-deferred
----------- plans must be accounted, and may be used as a deduction
against income withdrawn from the plan.
The reason for this is that, as noted under Component 4, capital
gains on such securities represent, on average over time, corporate
income that has already been taxed. Therefore it should not be
taxed further when the gain is realized and withdrawn from the plan.
- While this has the drawback of introducing the calculation of
capital gains in tax-deferred (registered) plans -- a calculation
eliminated in taxable plans by Component 4 -- the calculations
required would be somewhat simpler. E.g., since capital gains
would here be used as a tax deduction, there would be no benefit
to the investor from capital losses. Thus there would be no need
for rules concerning the mathematical fiction known as the
superficial loss. (It is not recommended to introduce new rules
about "superficial gains".) Also, the capital gain should be
recorded on a plan-by-plan basis, another simplification.
SUMMARY
=======
The plan outlined above is a rational and necessarily radical
re-thinking of several general aspects of income taxation in Canada.
It provides transparent taxpayer fairness by insisting on single
taxation of income streams which originate in corporate profits and
terminate in the hands of investors.
It has several welcome simplifications, such as those concerning
dividend taxation, capital gain calculation and income reporting for
income trusts.
It eliminates existing distortions and creates or maintains a fair
and level playing field between the following areas:
* Income trusts vs. other trust entities. [Component 1]
* Corporate taxation vs. individual investor taxation.
[Component 2]
* Corporate vs. FTE structure. [Components 1 and 2]
* Dividend income vs. ordinary income. [Component 3]
* Dividend income vs. capital gains. [Components 4 and 5]
* Taxation for taxable vs. tax-deferred investment plans.
[Components 3, 4 and 5]
With these factors being in better balance, businesses would choose
between the corporate or FTE structure driven largely by reasons
other than taxation. By the same token, investors would choose to
allocate their capital among such vehicles not driven by tax
reasons. These outcomes enhance competitiveness and efficiency.