Finance Committee on May 29th, 2007

[James G. Morand]

The thin capitalization rules as currently drafted don't apply to trusts, so there'd be nothing for GAAR to apply to. GAAR is nothing more than another section in the Income Tax Act, and its application is in the context of the Income Tax Act and whether or not there's an abuse of the Income Tax Act.

The thin cap rules are drafted and specifically do not apply to trusts. So in my view, GAAR would not apply to impose the application of the thin cap rules to existing income funds, as currently drafted.

If an amendment to the thin cap rules were made, then it's a different story. But as currently drafted, there's nothing for GAAR to apply to.

[John McKay, Liberal, Scarborough—Guildwood, ON]

I wanted to bring you back to your presentation with respect to ordinary partnerships.

I think you actually make an interesting point that there is some enthusiasm to get this legislation through, and therefore the rules haven't been well thought out. Just as an example, would your law partnership be potentially caught up in something of this nature?

[James G. Morand]

No.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Is that because it's private?

[James G. Morand]

It's for a number of reasons. The law partnership is restricted; the members are restricted to lawyers. You don't have the situation of a public corporation, or a corporation or entity with public debt, that is a member of the—

[John McKay, Liberal, Scarborough—Guildwood, ON]

Okay, I have chosen a poor example, but give me an example of an ordinary partnership that in your view is unintentionally caught up by this kind of poor drafting.

[James G. Morand]

Sure. Assume you have a private corporation, so its equity is not publicly traded. It is a private corporation with equity not traded. It has a greater than 50% interest in a partnership; there are other partners, and they're going to develop a specific property, a resource property. It really doesn't matter what the focus of the business is. That corporation issues debt in the public market and then uses that debt to finance its investment in the partnership. Again, it's not a partnership whose equity is publicly traded.

Based on the current drafting, that partnership becomes a SIFT and is treated as a corporation and is subject to these rules. Although, as you may know, partnerships are not taxable themselves, all their income gets allocated out to the partners and is taxed in the partners' hands, so what you're doing is imposing a level of corporate tax on the partnership, even though all of the income of the partnership would be allocated out to the partners, and in this case one of the partners is a corporation that is going to be taxed anyhow.

[John McKay, Liberal, Scarborough—Guildwood, ON]

You had another point with respect to rollovers. There's a transition period of four years here—

[James G. Morand]

Right.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Why is it so important to be very clear right now about the rollover rules?

[James G. Morand]

It's because it's affecting the decision-making that's taking place now as to what they're going to do on the SIFTs, because right now there is no rollover rule. There have been positive noises made by officials at the department that a rollover rule will be implemented, but there's no commitment for it, and we've been told it's not a priority.

[John McKay, Liberal, Scarborough—Guildwood, ON]

It's not a priority?

[The Chair, Conservative, Brian Pallister]

Mr. Morand, thank you very much.

I'll just venture in here a bit.

Madam Urquhart, you raised a number of points in your presentation. The one that stuck with me was the fact that the income trusts have largely recovered the so-called losses, the theoretical losses, that occurred following the announcement by the finance minister.

You said minus 3% relative to that value, and then you went on to say that the values have lagged the TSE. What did the values of the income trust index do in the six months prior to that announcement vis-à-vis the TSE index?

[Dianne Urquhart]

I don't know that factually, but I believe the average annual for the prior three years was approximately 20%, so I'm going to guess it's 10%. It would have been a substantial return because there had been such a flow of billions of dollars of the retail market into the income trust area. Since close to half of the income trusts are energy and the energy price was escalating, there was outstanding performance prior to that.

[The Chair, Conservative, Brian Pallister]

To just restate that yield, did you say that in the three years prior, there would have been a 20% average annually?

[Dianne Urquhart]

I think the average annual for the prior three years was approximately 20%, so they had become overvalued.

[The Chair, Conservative, Brian Pallister]

It's 60%. Okay. Just to be clear, if I held them for three years prior to October 31 of last year, I would have made 20%, plus compounding, each year for the previous three years. If I held them to now, I would have a net yield of something over 60%, minus the 3% you say, so I would have made 57% if I held them for three years and six months. The only way I'd lose money on them would be by selling them the day after the announcement was made, and this would be ridiculous for anyone with basic investment knowledge.

[Dianne Urquhart]

But if you bought them just prior and you sold them just after, you had a loss.

I would like to note that our call for a criminal investigation was made because there are 50 names that are down 20%. Someone who was not properly diversified or who unfortunately had a high proportion of what we call the struggling business income trusts could have catastrophic losses. A number of people did present to this committee indicating that they had done so, and we say that wasn't the—

[The Chair, Conservative, Brian Pallister]

Yes, exactly. That's a concern. I'm sure any member of our committee who had any bit of objectivity would have been touched by the stories told to us by some of the investors who came here, but all, without exception, were overweighted in income trusts, and that speaks to the industry's advice somewhat as well.

The other point that's being made, and you alluded to it a little bit, is the foreign takeover issue, this fear that we'll push all these income trusts into the hands of evil foreigners. I'm curious as to whether that was happening in the six months prior to the announcement.

[Dianne Urquhart]

I think we had a few acquisitions prior. I think that if the master limited partnerships are entitled to come here and buy income trusts and not pay business taxes as a result of the belief of a tax advisor such as James, who is sitting next to me, that they're not going to be able to apply the thin cap rules to the corporate subsidiaries, then you will have the master limited partnerships coming up here and buying the income trusts. That's because essentially you've taken a tax advantage away from individual Canadians and given it to the owners of the master limited partnerships in the United States, so they'll be a premium bidder. That's why it's urgent that this matter be addressed.

If you are concerned about being fair to individuals who have a tax advantage removed, then you must not give the tax advantage to foreigners, and if James Morand is saying that GAAR and thin cap can apply, then you've got to make an adjustment to this income trust tax package; you've got to take the publicly traded out so that it's very clear that it applies.

I'm not a tax expert who gets paid for tax advice, but that's probably a good thing because I don't have a commercial interest in this. It's still my opinion that the thin cap rules very clearly apply to corporate subsidiaries. While they might not apply to income trusts, virtually all income trusts have a corporate subsidiary, so what I'm saying is see through the income trust and have CRA apply that thin cap rule and the GAAR to the corporate subsidiaries.

[The Chair, Conservative, Brian Pallister]

Thank you. You've been clear on that point.

We'll continue now with Monsieur St-Cyr.

Mr. St-Cyr, you have four minutes.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

Continuing with the question of the value of income trusts, I would like to say that the Bloc Québecois has been asking for a moratorium on this for a long time. We are reasonably happy with the measures that have been taken, even though we think that the transition period could have been longer.

I have a question on the inflation in the share values of income trusts that we noticed in the years before the announcement. Is there reason to believe that the Conservative Party's promise to never tax income trusts helped to inflate their value even more? After all, potential investors saw these trusts as a very tempting investment vehicle, because the government of the day was promising never to touch them.

[Dianne Urquhart]

The business income trusts and the energy trusts were about 50% overvalued prior to the announcement. I've estimated that taxes are about 10%, so the promise not to take a tax would have kept them 10% above where they should have been--but there was another 40% overvalue, in my opinion, as a result of the deceptive cash yields. This was cash that was paid out that was not earned, cash that was needed to sustain the business by replacing the depleting reserves in the energy trusts and replacing and maintaining the plants.

Primary Energy Recycling just cut its distribution by a third. They didn't have a dollar set aside for maintenance. Guess what? What was the reason for needing to cut the distribution? Major maintenance was required in one of the five plants for energy recycling for electrical generation. That was a clear case to show the distribution was far too high, and the price was far too high, and it was sold that way to seniors in the Canadian market by an American businessman who couldn't raise the money in his own market.

[Thierry St-Cyr, Bloc, Jeanne-Le Ber, QC]

Fine.

You mentioned current rules preventing tax avoidance, and the way in which the Canada Revenue Agency could use them, for income trusts or for other reasons. During our hearings, we have also talked about double-dipping.

To prevent double-dipping, could the agency use its anti-avoidance rules, which prohibit a structure being set up simply in order to pay less tax and with no real commercial validity?

[Dianne Urquhart]

I'm not experienced enough or expert enough to make a comment in the area of application of GAAR to double dipping, but in the case of the interest deductibility for third-party debt raised to fund foreign acquisitions, the GAAR and the thin cap rules apply to non-arm's-length debt.

If a company is levered up because the banks are willing to give them 99% debt—and banks of the world do not give 99% debt—basically, in the income trust situation, it's the non-arm's-length debt that enables the avoidance of tax. It's on that basis that I say GAAR and thin cap rules apply, because it's clearly non-arm's-length debt, whereas in the case of interest deductibility, it was actually seen to be a problem for the Canadian banks because they wanted the ability to provide billions of dollars to Canadian corporations so that they could take the proceeds of that to acquire foreign operations.