Tuesday, December 18, 2007

Flaherty's Mini Budget: What became of leveling the playing field?

John McCallum asks a question of the Harper government

Q-1492 — November 29, 2007 — Mr. McCallum (Markham—Unionville) — With regard to the tax on income trusts announced on 31 October 2006, using the same model that was used to calculate the government’s estimates of tax leakage described by the Minister of Finance during his appearance at the Standing Committee on Finance on January 30, 2007, what would the government’s estimates of tax leakage have been if the corporate tax rate had been 15% rather than 21% as they were in 2007?

Trusts Redux: Tax Policy Suitable for Halloween

As an economist I welcome Minister Flaherty’s October 30 announced intention to boost Canadian productivity and prosperity by reducing the general federal corporate income tax rate to 15 per cent by 2012. The measure should be embraced by all: It will position Canada favorably in the global economy for decades to come. But while I laud the strategic direction on corporate taxes, I continue to question the government’s consistency on tax policy in general.

A year ago today the Minister announced in his Tax Fairness Plan his intention to “restore balance and fairness to the federal tax system by creating a level playing field between income trusts and corporations,” to eliminate tax leakage and to remove distortions in investment decisions. To paraphrase the Department of Finance’s analysis, the avoidance of corporate taxes from entities after conversion to an income trust is not totally offset by the taxes paid on income trust distributions from individual unit-holders; therefore tax leakage. The Minister estimated that annual tax leakage was in the order of $500 million and stated that something had to be done “to restore balance and fairness in the tax system”. The Minister’s solution to create “tax fairness” and eliminate tax leakage was to implement a 31.5% Distribution Tax on trusts in 2011 and to not allow any new conversions to the income trust form. The market response to the “Tax Fairness Plan” announcement was very negative.

Having worked for the income trust industry and with the Department of Finance on determining the appropriate methodologies for tax leakage, I presented evidence on the tax leakage issue to the Parliamentary Standing Committee studying the issue. To be precise, I raised several concerns with the Department of Finance approach – all of which went to a “sharp over-statement” of tax leakage. The major flaw in the Department of Finance analysis was that it did not take a lifecycle view of the tax leakage issue but rather focused on a 2006 “test year”. By failing to account for the reality that corporate tax rates were legislated to be reduced to 19 percent by 2011, the Department took a short-sighted and punitive approach to the issue. Despite the debate and a dissenting Committee Report “Taxing Income Trusts: Reconcilable or Irreconcilable Differences”, the income trust provisions of the Tax Fairness Plan remain in place.

It is regrettable that the October 30 announcement did not occur a year ago. It would have all but eliminated the perceived tax leakage issue without the punitive distribution tax on income trusts. In fact, the Department of Finance’s own Tax Leakage Model would have given an estimate of merely $80 million in tax leakage when accounting for yesterday’s corporate tax cuts instead of the $500 million stated by the Minister at the time. The Department’s own analysis would not have supported a tax on income trust distributions. If the October 30 announcement had been made last Halloween, the billions lost by investors would not have occurred and the playing field would have been leveled by 2011 – all this according to Department of Finance methods of analysis. These losses cannot be recovered and one has to question the path that led us to this point and Finance’s tax policy strategy.

I believe that even the $80 million estimate sharply overstates the leakage. This aside, yesterday’s corporate tax cuts would now allow the abolishment of the income trust distribution tax all together without incurring federal tax leakage – this, again, according to the Department of Finance’s own model.

Dennis Bruce is Vice President with HDR Decision Economics and has studied the income trust tax leakage issue since 2003. He twice testified before the House of Commons Finance Committee on the question Income Trust tax leakage.

Dennis Bruce
Vice President
HDR | HLB Decision Economics Inc.
1525 Carling Avenue, Suite 500
Ottawa, Ontario
Tel: 613-234-0080
Cell: 709-632-1708

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