The Conservatives and Income Trusts - Nov 4

I haven't posted in a few days so I'm breaking the shut out by posting this interesting development. As I understand it, the Harper gov't has closed a major tax loophole that was bleeding this country dry. Even the Liberals and the NDP were aware of this, so don't expect them to cry too much over it. The whole BCE and Telus announcements amounted to giving the gov't a big fat middle finger, a move that no gov't will ever take sitting down. After all, other companies would follow and the gov't would be out of the loop. In this article stratfor suggests that this may prove to be a positive thing for the majority-seeking Conservatives come election time in 2007.

Johnny Cash

Canada: A Tax Loophole Closes
Nov 03, 2006

Summary

The Canadian government has unexpectedly and abruptly closed a tax loophole -- a move that has raised an angry outcry among investors. Despite accusations of false promises and irresponsibility, the government may have just secured itself a stronger mandate.

Analysis

The Canadian government announced Nov. 1 that it plans to end the tax advantages of a popular corporate structure known as an "income trust." An income trust is a "flow-through" entity that allows companies to distribute income to shareholders from pre-tax profits rather than from taxed profits, as is the case for a standard corporation. The structure proved popular not only with Canadian firms seeking tax breaks, but also with foreign investors seeking a regular source of dividends; most trusts pay out their profits as dividends as they receive them, granting holders of their stocks regular (often monthly) sources of income.

The Nov. 1 move came as a surprise; the Conservative government, elected earlier this year, had campaigned on a pledge not to raise taxes on trusts.

Many in the financial community responded angrily to the decision, denouncing the move on various grounds -- that it is a betrayal of investors, that it is bad for the Canadian economy, that financial flows will avoid the country and that the surprise announcement sucker-punched the markets. As one might expect, investors reacted rather badly to the news, with the Toronto Stock Exchange (TSX) diving 2.38 percent Nov. 1. Predictably, the 255 income trusts listed in the market were the worst hit, typically losing between one-tenth and one-fifth of their value.

Yet, despite the Conservatives' campaign promise, ending the income trust tax structure was both an inevitability and a necessity. Income trusts in Canada had effectively become a major tax loophole that had gotten out of hand.

Once confined mainly to the real estate and energy sectors, Canadian income trusts have ballooned to include companies across a broad spectrum of the economy. The trusts currently make up 11 percent of the TSX's market value -- roughly CAN$230 billion (US$205 billion) in market capitalization. Until the Nov. 1 change, Canada was alone among the major states in allowing such trusts to function in any broad manner. The old law did bring in billions in investor cash as foreigners sought a way to get regular, tax-free income, but this influx came at a cost.

First, the spreading popularity of income trusts essentially changed Canada's tax structure by shifting the burden away from corporations and toward personal income tax. Second, because the tax exemption applied only to distributed earnings, as opposed to retained earnings, it altered how companies allocated their profits. They now had much less incentive to retain those earnings and reinvest them in equipment, technology or other assets that would generate future growth in the economy. Put another way, Canada was becoming a sort of offshore financial center, at the cost of lower investment in its own economic development.

The final straw for the government was a recent pair of announcements by two of Canada's biggest companies -- telecommunications firms Telus Corp. and BCE Inc. -- of their intent to convert themselves into trusts.

Although those affected by the change have been vocal, the long-term fallout will likely be minimal (at least among those not enamored of the income trusts). The change will be phased in during the next four years for existing trusts, easing the transition. Indeed, Nov. 2 -- the day after the TSX's 2.38 percent fall -- the index recovered slightly, ending up 0.67 percent. Valuations of companies structured as income trusts will fall somewhat as investors who were only interested in the income trust structure move on, but even though their overall tax burden will obviously rise, such firms' underlying fundamentals will be unchanged.

One potential effect will be a temporary weakening of the Canadian dollar from its current level of about 0.89 to the U.S. dollar, as those foreign investors who came to Canada only for the income trusts -- accounting for slightly less than one-quarter of that market -- pull out their money. Many of these foreigners collect the pretax distributions the income trust system allowed and then repatriate the dividends to their own countries, often circumventing their local tax authorities. The trusts have been particularly popular with U.S. investors. Foreign investors in Canadian markets may therefore be particularly prone to liquidate their investment trust holdings and, by extension, their Canadian dollar holdings.

Though investors will no doubt hotly dispute it, the decision may even increase support for the government. The Conservatives are not a monolithic party but a coalition of two factions: a federalist, pro-business faction that is the remnant of the former Progressive Conservative Party, and the populist and confederal faction -- led by current Prime Minister Stephen Harper -- formerly known as the Canadian Alliance Party (which itself originated from the Reform Party).

Harper will have little problem explaining to his grassroots allies in Canada's Prairie Provinces that a tax regime allowing foreign investors and big business to evade taxes needed changing -- a line that may well appeal to the left of Canada's political spectrum as well.

And although business leaders -- predominantly supporters of the Conservative government -- are currently wailing and gnashing their teeth, their loyalty to the government is secure. After all, they certainly are not going to throw their lot in with the scandal-ridden (not to mention leaderless) Liberal Party, which they just recently helped throw out of government, much less the left-wing New Democrats or the Bloc Quebecois.

All this will be of critical importance in the coming spring when the Conservatives intend to call for early elections in hopes of strengthening their current minority government. Far from destroying the government's credibility, the income trust issue could, in a few months, be the issue that secures the Conservatives a new -- and much stronger -- mandate.

Copyright 2006 Strategic Forecasting Inc. All rights reserved.