Finance Committee on Feb. 1st, 2007

[The Chair, Conservative, Brian Pallister]

I call the meeting to order.

Thank you; we appreciate your being here this morning as we continue our study on income trusts pursuant to Standing Order 108(2).

We have enjoyed our first session and look forward to your presentations today.

I'll ask the media now if they would reduce their participation to zero. Thank you.

On behalf of the finance committee, thank you again for your presence here today. We've asked you to confine your presentations to a brief five minutes. I will give you an indication when you have a minute remaining in order to give you a chance to wind up your presentations. At the five-minute point I will be forced to cut you off to allow time for exchange with the committee members after your presentations.

[John McCallum, Liberal, Markham—Unionville, ON]

I have a point of order, Mr. Chairman.

[The Chair, Conservative, Brian Pallister]

Go ahead, Mr. McCallum, on a point of order.

[John McCallum, Liberal, Markham—Unionville, ON]

I'd like to propose, in view of the extreme shortage of time and the large number of witnesses, that we extend our sitting to end at 1:30, which would give an extra 15 minutes to each session.

[The Chair, Conservative, Brian Pallister]

We'll see how it goes, Mr. McCallum.

We'll commence now with a presentation from Mr. Fortin.

[John McCallum, Liberal, Markham—Unionville, ON]

Mr. Chair, I would like to have a ruling on that, please.

[The Chair, Conservative, Brian Pallister]

You will not get a ruling.

Mr. Yves Fortin, you will begin now with a five-minute presentation. You may commence.

[John McCallum, Liberal, Markham—Unionville, ON]

We challenge the chair.

[The Chair, Conservative, Brian Pallister]

The chair has been challenged.

I'm asking for a vote now of the committee members. I have been instructed previously that we would be 11 o'clock to 12 noon with the first panel and 12 noon to one o'clock with the second. I'm going to try to follow the previous instructions committee members gave me, and I'd ask you to support the chair at this point. If you do not, so indicate.

(Ruling of the chair overturned)

The chair's ruling has not been upheld.

Mr. McCallum, what do you propose?

[John McCallum, Liberal, Markham—Unionville, ON]

I propose that we have an extra 15 minutes for each session. We would go from 11 o'clock to 12:15 and then from 12:15 to 1:30.

[The Chair, Conservative, Brian Pallister]

All in favour of Mr. McCallum's proposal?

[Some hon. members]

Agreed.

[The Chair, Conservative, Brian Pallister]

Then let's go.

Mr. Fortin, over to you for five minutes.

[Yves Fortin, As an Individual]

Thank you, Mr. Chairman.

I would ask the committee members to refer to the written statement and papers that I have tabled, to better understand the very telegraphic points I will make.

My thesis is that it is the implementation of the legislative proposals, and not the existence of the trusts, that will lead to a loss of tax revenue. The attempts to quantify the alleged tax leakage go back to the 2005 consultation paper. That study suffered from fundamental flaws. Because of its many incorrect assumptions, the study overestimated the taxes collected from corporations and underestimated the taxes paid on trust distributions. The updated numbers released by the minister, and earlier by Mintz, are based on the same faulty methodology used in the consultation paper.

The worst source of leakage, according to the minister, is the RRSPs and the pension funds, because he treats them as tax-exempt rather than tax-deferred entities as they are under the law. In a medium- and long-term context, there could only be tax leakage if the present value of taxes paid in the future were inferior to the taxes forgone at the present time. This cannot be, since the yield on trust units is 8% or 10%, while the rate of inflation is about 2%.

The minister says he has to look at the issue from the point of view of the annual budget. This cash accounting method cannot be used to pretend that taxes are not paid and that this causes him a problem. In 2004, Canadians contributed $38 billion to their tax deferred accounts but withdrew $52.5 billion of income fully taxed at their highest marginal rate. There is clearly no leakage even on the basis of the current fiscal year.

The measures contained in the draft legislation will lead to a substantial loss of tax revenue for the following reasons.

The non-tax-deferred investors pay more taxes on trust distribution than they would if the trusts were corporations. This is because their taxes are calculated at the higher tax base and paid at higher-taxed personal rates. If most or all trusts reconvert to corporations, as is clearly the intention of the minister, the taxes collected will be reduced substantially.

Because of heavy double taxation of distributions, RRSPs, RRIF-holders, and pension funds will have to shift their investment to assets with lower yield. This will lead to lower retirement income, year after year, on top of the heavy capital losses they suffered. Less retirement income will lead to lower tax revenue and more pressure on the social welfare system.

In view of this, there is clearly a need to adopt a package of measures to truly compensate people who lost a chunk of their retirement savings. The increase in the age tax credit, worth $150 a year, is pretty useless for a person who has lost $15,000.

Pension income splitting is welcome, but it is highly discriminatory and its linkage with the trust issue is purely artificial. Due to much higher taxation, non-residents will divest away from their trust units and the government will lose the quasi-totality of the withholding taxes presently collected. The minister thinks these investors don't pay enough taxes, so his solution is to make sure that they will pay none.

Most provinces will be affected negatively, not only due to a global lower tax base but also by the fact that trust distributions will be taxed by the province where the trust resides and not by the provinces where the investors reside as is now the case. Provinces such as Quebec, B.C., and Manitoba, which have an active investment community but host few or no trusts, will be losers.

My overall conclusion is that the legislative proposals should be put on hold until, one, a credible study, based on sound methodology, made by a neutral party, is made to determine their impact on tax revenue; two, a set of measures is put forward to truly compensate the losses suffered by persons saving for their retirement—the attitude of the minister is callous; and three, a set of criteria and regulations is proposed to determine which types of enterprises should be allowed to convert and those that should not.

It is the absence of such criteria and regulations that has led to the destructive overkill and the damage that we are witnessing. The minister did not have to destroy the trust sector in order to prevent the undesirable proliferation of conversions such as EnCana, Hibernia, Bell, and Telus.

Thank you, Mr. Chairman.

[The Chair, Conservative, Brian Pallister]

Merci, Monsieur Fortin.

We will continue now with Gordon Tait, from BMO Capital Markets. Mr. Tait, five minutes is yours.

[Gordon Tait, Managing Director and Research Analyst, BMO Capital Markets]

Thank you for the opportunity to address the committee. I've been a royalty and income trust analyst for over ten years, and as an independent analyst, the views I express are my own.

There are a couple of areas I want to highlight that I think are quite relevant to the discussion. First, as you know, it's impossible to talk about income trusts and not talk about tax. I've done quite a bit of work in this area and I've submitted the results of our study for you to see.

I've seen the analysis produced by the Department of Finance, and although it shows more numbers than I had received a couple of weeks ago, it still doesn't show enough detail to really see where their results differ from ours, so I think we need to see more company-specific details in the same way that we have disclosed them in our study.

In the study we did, we used exactly the same assumptions as the Department of Finance, even though I believe some of those are flawed. For instance, we estimate that approximately one-third of the trusts that are held in retirement accounts are in what you would call tax-paying retirement accounts, things like RIFs and pensions. There are annual withdrawals, and they are being taxed regularly. Nonetheless, we did it in the same way that they had done theirs.

We looked at 126 businesses that actually converted to income trusts between 2001 and 2005. We compared the actual amount of tax that had been collected from those businesses as corporations prior to their conversion with the amount of tax that was collected from the trust in the first year by taxing the distributions under the DOF methodology.

What we found was that on average the government collected about 1.5 times as much in cash tax revenue from the trusts as they had collected over the average of the previous three years by taxing the same businesses--the same assets--as corporations.

For the royalty trusts, the difference was even greater. We found that the government collected, on average, over four times as much tax from the trust distributions as had been previously collected from the corporations, so when we look at the empirical evidence, not just a theoretical model, what we see is that generally much more hard cash tax is is collected from them as trust entities than as corporations.

There are really three primary reasons for this. First of all, trust payout ratios are typically much higher than dividend payouts, so more of the cashflow is actually being subjected to tax at individual marginal rates. As well, of course, individuals pay tax at higher effective average rates and higher tax rates than do corporations. Lastly, and this is the most important thing, corporations have many more ways to avoid or minimize paying taxes than do individuals, so in an actual cash tax comparison, we find that the government collects more taxes from the trusts than from the corporations.

The rapid expansion in the trust market has always been driven, in my view, by the demand for yield, and not because of taxes, and that's not going to change. The demographic investment needs of this country are changing. A 70-year-old's investment objectives are just not the same as a 30-year-old's, and we all have to recognize that, so we have to be very careful before we dismantle the only high-yield market that Canada has.

I think the tax fairness plan makes a good start at levelling the playing field between corporations and income trusts. I think much of the disparity, though, centres on the double taxation of income and dividends; that's where the problem lies. I think that lowering the level of tax on corporate income and dividends is the way to eliminate the tax incentive to convert to a trust.

But the tax fairness plan also introduces one unfortunate consequence: it creates a two-tiered investing landscape in Canada. It's one that favours large institutional investors, private equity players, and large pension funds over ordinary Canadians. That's all because of three words: “publicly traded trust”. The plan taxes only the distributions from publicly traded trusts and FTEs, and not the same structures when they are used outside the public markets.

So first you have to understand that what we call an “income trust” is really a very generic structure; there's no special tax loophole. It's basically a mutual fund that owns the debt and equity of a company. These debt and equity instruments are widely used in both private and public funds. Income is typically shifted from the corporation to the trust unitholders via the interest on the debt.

Now trusts, in a sense, pay their distributions through the debt side of a company's capital structure, whereas corporate income and dividends are typically taxed at the equity side. The advantage is they are only taxed once, so one of the problems of the tax fairness plan is that it levies that 31.5% tax only on the distributions of publicly traded trusts and flowthrough, leaving all these other capital market players to use exactly the same structure over exactly the same assets--and they avoid having to pay the tax.

I'm not advocating another system of double taxation to level the playing field, but there are other solutions. Once again I would urge you to consider some modifications to the current proposal so that once again it's not just the average, ordinary Canadian who gets hit with yet another tax.

Thank you.

[The Chair, Conservative, Brian Pallister]

Thank you.

We continue with the president and CEO of Manulife Financial, Mr. Dominic D'Alessandro. It's a pleasure to have you, sir. Five minutes is yours.

[Dominic D'Alessandro, President and Chief Executive Officer, Manulife Financial]

Thank you, Mr. Chairman.

Honourable members, thank you for the opportunity to appear on this important issue. I will be very brief.

It's my opinion that the income trust sector in Canada is increasingly populated by businesses other than those whose principal activity is the operation of real estate or royalty-producing assets. It is worth remembering that it was for such businesses that the current tax regime was originally designed.

In June of last year, CI Financial converted to trust status. Subsequently, Telus and BCE announced plans to convert. We at Manulife Financial engage in a number of businesses in Canada. Some of these businesses could quite conceivably be structured to qualify for income trust treatment. I think this is true for many if not all of the other financial institutions in Canada. We would all, in time, have faced intense pressures to break up our companies.

I also have reservations with the appropriateness of some of the businesses that have been sold as income trusts. It is the tax treatment of the distributions that is driving the public's appetite for investment in the sector, and I don't think this is the best way to allocate capital within an economy. After all, capital is important for all companies. Capital provides confidence to employees, suppliers, and customers; capital allows businesses to cope with downturns in activity; and capital provides the means with which to take advantage of growth opportunities that may present themselves in the marketplace.

I don't know why we would want a tax regime that would discourage the accumulation of an appropriate level of retained earnings by the corporate sector.

In time, if left unchecked, the income trust sector would spread to encompass the core of our economy, and I don't think that would be a good thing for Canada.

I leave it to the tax and other specialists to opine on whether the specific approach taken was the most ideal solution; however, I do applaud the government for dealing with an important issue.

I'd be pleased to answer any questions.

Thank you very much.

[The Chair, Conservative, Brian Pallister]

Thank you, sir.

David Dodge is here from the Bank of Canada.

It's nice to see you again, sir. It's over to you.

[David Dodge, Governor, Bank of Canada]

Good morning, Mr. Chairman, and members of the committee.

I should start by making clear where the Bank of Canada's main interest in the income trust sector lies. Our interest in income trust relates to the efficient functioning and health of Canada's financial system. A safe and efficient financial system is essential to Canada's economic well-being. The Bank of Canada works with other government agencies, as well as market participants, to promote the safe and efficient functioning of the financial system. Capital markets are a key component of that system. And so we are naturally interested in developments in financial markets—such as the evolution of the income trust market—that has the potential to affect financial system efficiency.

With that introduction, Mr. Chairman, let me quickly summarize the highlights of the bank's work on the topic.

l refer committee members to our June 2006 Financial System Review. In that publication, we noted that limited evidence suggests that income trusts can enhance market completeness in a number of ways. Income trusts can provide diversification benefits to investors, because trusts can have different risk-return characteristics from those of either equities or bonds. Second, the income trust structure appears to allow some firms improved access to market financing.

Insofar as income trusts allow investors to achieve risk-return benefits they couldn't otherwise achieve and serve as a source of financing to firms that might not otherwise have access to markets, it can be said that income trusts enhance market completeness and therefore support efficiency.

But we note in the same article two areas where the standards for trusts really don't come up to those for corporations, and where improvement is clearly needed: in standards related to accounting and distribution of revenue and those related to governance.

These are the aspects, committee members, that we at the bank have specifically looked at. Of course, there are very important public policy questions related to income trusts that fall well outside the bank's mandate. The bank has done no specific research on how the income trust structure affects economic performance or would affect future productivity in Canada.

Based on general economic principles and our understanding of the structure of the Canadian economy, I can say that while the income trust structure may be very appropriate where firms need only to manage existing assets efficiently, it is definitely not appropriate in cases where innovation and new investment are key. To the extent that the system was favouring the use of the income trust structure, in these cases the incentives for innovation and investment were reduced and potential future productivity growth was reduced.

Finally, members of the committee should realize that different risk-return characteristics of trusts may not enhance market completeness, if they arise from differences in tax treatment. Clearly, there has been a very significant tax incentive to use the income trust form of organization in cases where this would not have been an appropriate form of organization from a business efficiency point of view.

By giving incentives that led to inappropriate use of the income trust form of organization, the tax system was actually creating inefficiencies in capital markets—inefficiencies that, over time, would lead to lower levels of investment, output, and productivity.

We at the bank have not done any research on how the rules of the tax system could or should be designed so that they do not give inappropriate incentives. The changes proposed by the government last October would appear to at least substantially level the playing field. For the income trust sector to deliver the efficiency benefits through its enhancement of market completeness, it is absolutely critical that the tax system provide a level playing field.

Thank you, Mr. Chairman.

[The Chair, Conservative, Brian Pallister]

Thank you, sir.

We'll continue now with Kevin Hibbert, who is chief accountant for Standard & Poor's.

Welcome to you, sir. It's your turn.

[Kevin Hibbert, Chief Accountant, Standard and Poor's]

First, I'd like to thank you all on behalf of Standard & Poor's Canada for inviting me here to participate in today's proceedings.

I want to use my opening remarks to give you some insight into how Standard & Poor's is structured and what my role is at Standard & Poor's, in order to give you a sense of the perspective we take in looking at the Canadian income trust sector.

Standard & Poor's is a division of McGraw-Hill companies, and in Canada Standard & Poor's consists of two main operating segments that are separate and distinct from one another, the first being the index services group, which focuses on managing our various market indices, such as the S&P/TSX composite index. The second operating segment is the rating services group, which focuses primarily on assessing the creditworthiness of rated issuers, income trusts included, and the stability of income trust distributable cash.

The ratings group provides the capital markets with objective analysis and ratings opinions but does not comment on the relative value or market price of a security or the suitability of a security for an individual investor. As director and Canadian chief accountant for Standard & Poor's ratings group, my role is to contribute to the analytic process by analyzing the various risks inherent in the financial reporting practices of rated issuers.

At Standard & Poor's, we clearly have a keen interest in any event that is consequential to our rated universe. This would include changes to tax policy. However, our view of tax policy is focused on the impact it may have on a company's specific credit or stability rating.

To appreciate the effects of tax policy on an income trust, we pay particular attention to the business risk and financial risk profiles of the company, in addition to the specifics of the tax policy. This type of analysis is central to what we do as an organization. It provides us with insight into the risk profiles of different income trusts but does not position us to offer opinions on the merits of any particular tax policy.

Since last year, I've been engaged in a continuing study of the consistency and adequacy of financial reporting by income trusts. A two-part report that I co-authored entitled “Canadian Income Trusts and the Perceptions of Distributable Cash” found substantial inconsistencies in the reporting practices of income trusts, in some cases leading to significant over-statements of distribution capabilities.

In recent months, market participants have taken steps to improve the quality and consistency of income trust reporting and disclosure, in part driven by disclosure standards put forward by the Canadian securities administrators and the Canadian Institute of Chartered Accountants.

It should be noted that our observations did not speak to the legitimacy of the income trust structure as a whole and were not intended to single out income trusts as poor reporters; rather, our intent was to underscore to investors the fact that financial reporting risks evident in the earnings figures of corporations are just as prevalent in the cash-generation figures of income trusts. Consequently, investors were encouraged through our reports to maintain the same level of vigilance in assessing reported numbers of income trusts as they do for the reported numbers of corporations.

Finally, I'd like to provide two observations for the committee's consideration this morning.

First, the impact of the proposed tax fairness plan on our rated universe of trusts is by no means homogeneous. Several factors related to an individual income trust's business risk and financial risk profiles will determine the plan's impact, and consequently our response within the analytic process.

Second, it's very difficult to generalize about the extent to which income trusts engage in sufficient, appropriate reinvestment within their businesses. That issue requires a fundamental, case-specific examination of the specifics of each income trust, business risk, and financial risk characteristics. In this regard, income trusts are not unlike conventional corporations.

That said, I welcome any questions you may have and hope that our specific insights can prove valuable to the committee.

Thank you.

[The Chair, Conservative, Brian Pallister]

Thank you very much, Mr. Hibbert.

We'll continue with Jeffrey Olin from Desjardins Securities Inc. Welcome to you, sir.

[Jeffrey Olin, Managing Director, Ontario, Head of Investment Banking, Desjardins Securities Inc.]

Good morning. Thank you for the opportunity to present to you and your committee today.

At the outset let me emphasize that I am a strong supporter of lower taxation policies in both the corporate and personal sectors and generally believe in free markets with less government intervention. At the same time, I'm generally supportive of the government's pursuit of policies that level the playing field from a tax perspective between trusts and corporations.

A key reason for this view is that I believe that fundamentally important decisions such as corporate or ownership structures should not be exclusively or primarily driven by tax factors. This perspective is not dissimilar to the notion that investment decisions should not be exclusively or primarily driven by tax factors.

To underscore this point, one might recall quotes in the financial press over the past two years from CEOs of major Canadian public corporations considering the transformation from a corporation to a trust, along the lines of “I have some reluctance to move to a trust, but the tax savings are just too significant and compelling.” My concern, and the reason CEOs have made comments like this, is that a corporate structure provides much greater flexibility for boards of directors and their management teams to manage the business affairs of the entity than do trusts.

This is particularly the case with respect to the rules governing trusts that require the payout of 100% of their taxable income in order to avoid the payment of tax at the trust level. Of course, many trusts pay out distributions that exceed their taxable income in order to be “competitive” from a yield perspective.

Accordingly, many business models may not be best suited to a trust structure, but they may be drawn to this structure simply because of the tax savings. As a result, trusts may have less internal capital available to pursue growth initiatives or reinvestment in capital expenditures. This could be quite detrimental to the long-term interests of the entity or the economy in general. At the same time, the substantial payout of a trust's cashflow positions it to be much more reliant on investment dealers, and in turn, institutional and retail investors to fund these growth and other capital initiatives.

Some stakeholders in this debate have argued this as being a good thing. I do not agree. These comments reflect an overplayed cynicism regarding the role and responsibility of corporate directors versus the influence of shareholders more directly. For example, if a trust needs to raise capital to pursue growth or reinvestment initiatives at a time when investor interest may have temporarily rotated to a different industry sector that is more in favour, or if the institutional unitholder base of that trust is experiencing redemptions from its own fund, the trust may be stymied from tapping capital markets at a critical time, and relative to a corporation, would not have the same availability of internal funds to pursue these initiatives. This undue reliance on and influence of capital markets on the management of a business is another key reason that CEOs and their boards have been reluctant travellers on their path to transform to trusts.

To move forward, what capital markets need, perhaps more than any other dynamic, is certainty. The rules upon which the government's proposals will be put in place need to be clarified and implemented. As one example, the government stated its intention to provide exemptions for REITs, real estate investment trusts, which would enable Canadian REITs to operate in a similar fashion to REITs in other jurisdictions, notably the United States. I strongly agree with this proposal, yet much uncertainty and confusion exists with potential divergence between the stated goals and proposed details of implementation.

To highlight this, I have brought and tabled the publicly available prospectus of a very recent public offering of a Canadian REIT. In it is some language, which I've highlighted for ease of reference, that may be unnecessarily alarming to investors. My recommendation in this regard is that if the public policy intent is to provide an important exemption for REITs, then let's get on with it and do so. Let's stop worrying about refrigerators, parking lots, and fences, rather than the bigger picture factor of property ownership and management.

Finally, it is folly to believe that there are not alternatives for investors, including seniors, to receive predictable yield-driven returns from investments that provide cashflow in excess of GICs or bonds. One example is convertible debentures, which not only provide a regular distribution of interest income, together with upside potential, but compared to income trusts would generally be a less risky investment, since debenture holders have an entitlement to a corporation's cashflow in preference to equity holders.

With respect to the most basic question of tax leakage, while I personally would place more faith in the work done by individuals such as Jack Mintz, as well as the finance department's analyses, than other analyses proferred—some of which have even suggested a net increase in overall taxes paid—I believe this question should be considered on a more fundamental and perhaps intuitive basis.

The responsibility that a board of directors holds is to consider the interests of the corporation not in isolation of its shareholders, but rather to serve the interests of its shareholders.

[The Chair, Conservative, Brian Pallister]

Mr. Olin, I'm sorry, I'll have to cut you off there. There will be time for questions, of course.