TAX LEAKAGE FROM INCOME TRUSTS -- HARPER’S BIGGEST WHOPPER!

Tax Leakage From Income Trusts??? Er, Would You Like To Talk About The Environment? ....

On Halloween Eve 2006, Canada’s Finance Minister introduced the framework for a draconian new tax scheme obviously intended to destroy the booming income trust industry. Ultimately, that “Made In Haste” initiative would lop off 25 billion dollars from the hard-earned savings of millions of Canadians who had invested in income trusts.

In fact, based on a national November 2006 poll, Ispsos-Reid estimated that four million Canadians actually suffered losses from the government’s actions. However, many Canadians didn’t realize that they were affected until they viewed their mid-January mutual fund statements.

Regardless, there must have been the equivalent of a national financial crisis for the Conservative government to act in such an arbitrary and draconian manner. After all, it was only about a year previously that Tory leader Stephen Harper had promised Canadian voters that if elected, he would “protect seniors” and “NOT tax income trusts.” Period. No qualifiers.

Um, now about the national emergency that provoked such Big Brother intervention in the financial markets by Mr. Harper and his minions. Er, well, it, um, er, you see, uh…perhaps we should let Rona Ambrose explain the whole matter…Oh, nix that idea; she’s no longer one of the P.M.'s favoured...

Instead, let’s talk about tax leakage from those vile dreaded, horrible income trusts -- the worst thing to afflict Canada since Belinda Stronach changed her hair colour.

Tax Leakage Research: Where’s The Beef?

Where were we? Oh yes, tax leakage from income trusts. That’s the terrible revenue deficit (allegedly lost taxes) suddenly experienced by Canada’s beloved tax collectors on Halloween Eve 2006. According to Finance Department studies…Oh dear, that’s right, there are NO Finance Department studies on this subject that anyone in the government is willing to produce.

In fact, here’s what John Dielwart, head of CCET (the Canadian Coalition of Energy Trusts), surprisingly discovered. When that group used Canada's Access to Information laws to obtain the analysis and research studies that Ottawa used before deciding to drastically change the tax status of income trusts, CAIF was told that “no such studies exist.”

Well, um, er…where’s Rona? Rona, maybe you could come forward and distract the reporters with that neat hair toss you always executed so perfectly every time you insisted that global warming doesn’t exist…Oh, dear, that’s right. Stephen says that global warming does exist now, and the Conservative Party is now greener than a bar of Irish Spring bath soap.

How can Canada’s Prime Minister indulge in such a blatant policy flip-flop? Well, you know what he always reminds the Cabinet. God can change his mind…

Never mind, let’s get back to income trusts…So about all that Finance Department research on tax leakage from income trusts…well, maybe it wasn’t Finance Department research. Maybe it was all that ‘sort-of’ research, guesstimates really, from Professor Jack Mintz and his cronies -- the “kind-of, sort-of’ studies that Finance bureaucrats read about in the Globe & Mail.

Well, here’s the scoop from Finance, by way of the Globe & Mail ROB section, by way of Jack Mintz and other ‘experts’ whose very flawed calculations on lost tax revenues ignited the recent government fatwah against income trusts: At least 500 million tax dollars were lost annually from income trusts…well maybe really only 320 million dollars…well no-one can really be certain, so …Rona! Help us out here, Rona! We need another distracting hair toss! Oh, never mind!

The Plan: Destroy 25 Billion of Canadians’ Savings & Collect 500 Million Dollars In Taxes

Anyway, for argument’s sake, let’s just say the tax loss to Finance Department coffers is 500 million dollars annually (well, that’s what the Finance guys originally said before publicly admitting that they had no concrete evidence to back up that brazen exaggeration). Not to mention that it was at a time when the federal government was experiencing the onerous financial burden of annual four-billion-dollar budget surpluses!

Imagine, 500 million dollars in lost taxes at such a time! It’s just such a terrible, frightening loss of government revenue which otherwise could have been wasted, er, invested in such high-priority government initiatives as bailing out money-losing, Quebec-based Bombardier yet again. Or perhaps buying some new multi-million dollar fighter jets to help out George Bush.

With these grave considerations in mind, who can blame Canada’s ruling minority government for resorting to a last-ditch emergency measure to recoup that alleged 500 million dollar loss in government tax revenues?

Who could argue with the Harper administration arbitrarily -- without any prior consultation -- intervening in the financial markets and causing a loss of 25 billion dollars of Canadians’ savings in order to get back that precious 500 million in tax revenues for the government?

After all, what is a twenty billion dollar haircut for Canadian investors, as compared to the tax department of Canada possibly losing up to 500 million dollars in taxes, even if Finance bureaucrats likely used the Globe & Mail as their research tool to come up with such fanciful numbers?

The Real Story: Red Herrings, Flawed Stats & Media Myth Making

So what’s the real scoop about all this alleged tax leakage from income trusts? Well, boys and girls, let’s go back in time when a noted business professor, Jack Mintz, wrote a series of policy papers urging the government to practice “tax fairness” and to “even the playing field” between public corporations (that is, corporate stocks like BCE and Telus) and income trusts.

However, as Professor Mintz has emphasized on more than one occasion, his original goal was to encourage the federal government to sufficiently reduce the tax on corporate dividends to make Canadian dividend-paying stocks just as attractive to income-hungry investors as income trusts.

That was the equal playing field Professor Mintz was advocating. Nowhere in his obtuse academic policy discussions did Professor Mintz suggest that the government should impose an additional tax on income trusts.

And nowhere did Professor Mintz criticize the tax-free “flow-through” structure that government legislation had originally mandated for the original royalty (energy) trusts and real-estate investment trusts.

Flow Through, Shmow Through? Who Cares?

By the way, here’s what was intended by the “flow-through” structure of the original government-legislated income trusts. Unlike public corporations, income trusts themselves were not to be subject to any tax. Instead they were mandated to directly “flow through” as much of their earnings as possible to income-trust investors (holding back sufficient funds to keep their businesses thriving, but not for spending on perks like executive jets, rigged stock options and ego-driven corporate buyouts).

Investors in income trusts would themselves pay tax on the income (distributions) they received from such trusts. But because of the direct “flow-through” nature of income trusts, more income would be paid to investors from income trusts than from comparable corporate equities (dividend-paying stocks).

That’s because conventional stock companies can retain most of their earnings for further expansion schemes and executive perks. For example, instead of paying out the bulk of their earnings to shareholders in the form of income (as must income trusts), corporate stock entities can use that cash to buy up other companies in totally unrelated business sectors -- buyouts which often turn out to be money-losing investments (just ask BCE about CTV). Or they can use it to pay for over-generous executive salaries, stock options or other executive perks. And they can also use “surplus” earnings to buy back shares of the company in the open market.

In other words, unlike income-trust CEO’s, executives of public corporations have long been permitted to use company earnings for just about any purpose other than directly paying out generous income payments to shareholders who theoretically own the company.

A Boon To Energy Producers

But why give such a generous “flow through” tax break to income trusts? Because initially this financial structure was to be used by energy producers (and later pipelines and other resource producers) to raise capital in a very depressed energy/resource market.

In particular, the income trust structure was designed as a unique way to attract investor money to the Western oil patch (and later the industrial real-estate industry), while providing investors in these financial instruments with more income in return for taking a higher investment risk than usual.

However, the one risk that no-one could have envisaged in 2006 -- from a government that had promised not to tax income trusts -- was an onerous new trust tax that ultimately will destroy the entire trust industry and result in the sell-out of uniquely Canadian trust companies to domestic and foreign private equity interests who have no intention of paying a cent in taxes to the Canadian government.

Regardless, let’s make one thing clear. Even if income trusts were paying no taxes to the federal government in October 2006, income-trust investors were paying hefty taxes on the income they received from their investments in trusts. And if these investors were affluent enough to be in the middle or highest tax brackets, they likely paid more tax, percentage-wise, to the government than any income trust would have paid if it had been taxed like a public corporation (common stock). Today, for example, the average corporate tax rate for major Canadian non-trust energy stocks is only about 16% (not the 30% figure bandied about by the Finance Minister), and there are some publicly-traded foreign energy subsidiaries that pay little or no tax to the Canadian government.

Talk about a massive “tax leakage” that politicians and bureaucrats don’t seem to care about -- in contrast to the current obsession with alleged “tax leakage” from income trusts!

Woops! Back To Professor Mintz


Anyway, back to Professor Jack Mintz and his trust policy papers. They were destined to end up in the garbage bin of policy-paper history if some enterprising business reporters hadn’t stumbled on one particular guesstimate of the good professor -- regarding how much tax loss the federal government was purportedly suffering from income trusts.

Welcome to the origins of the myth of income-trust “tax leakage.” Using a very flawed analytical model, Professor Mintz originally estimated that there was a tax leakage of more than 300 million dollars from income trusts, as compared to what would happen if trusts were treated taxwise as regular common stocks.

Suffice it to say that one of the biggest criticisms of Professor Mintz’s approach to the subject of income trusts was that he treated tax-deferred RSP income from income trusts as lost government tax -- because in the year that such income is received in a personal RSP, it is exempt from taxation.

That’s what’s called a present-value analytical model, ignoring future tax implications of such income. However, what is really needed to gauge tax reality is an analytical model that additionally calculates the deferred (future) taxes that the government will ultimately collect when RSP trust investors withdraw that same money from an RSP.

In fact, current untaxed RSP income actually represents a locked-in savings plan for the future, for government. Our politicians can’t immediately spend that trust tax money on the latest wasteful government boondoggles. Instead they must practice financial discipline and wait for the taxes to be paid out in future years (via mandated RSP withdrawals) when the government may have greater need for those tax revenues -- for example, in the next decade, when health and social services costs will likely spiral as Canada’s baby-boomer population ages.

So forget the Mintz-inspired “tax leakage” myth. Because of the good professor’s flawed analytical model -- and we’ve only dealt with one of this model’s shortcomings -- his and similar studies have generated an amazing amount of newspaper fiction writing, with regard to the alleged discovery of shortfalls in government tax revenue from income trusts.

The Myth That Won’t Go Away -- Flaherty’s Folly

The trouble is that the media (can you say, “The Globe & Mail,” kiddies?) and Finance Department bureaucrats won’t forget these income-trust tax studies. They have “reified” these outside findings -- treating questionable statistics on “tax leakage” as if these flawed numerical ‘guesstimates’ represent something that exists in reality, rather than in the minds of those who popularize such distorted research.

And then using this misinformation, on two occasions, Finance bureaucrats appear to have formulated government policy on the go. For example, in October 2006, they used a media-defined income-trust “crisis” as the excuse to advise Canada’s Finance Minister to take draconian action to stem an alleged “tax-leakage” tsunami which did not even exist.

In fact, as we shall discuss in a subsequent blog entry, there were plenty of good reasons for the government to take some action (though not necessarily for the reasons provided by the Finance Department). But there was NO reason for implementing the disastrous “take no prisoners” approach undertaken by the Finance Minister toward income trusts -- to destroy the existing income-trust market, as well as the ‘mom & pop’ investors who had invested in these financial instruments.

Closing Thoughts

Now, knowing what you now know about the tax leakage myth, what would you think of a Cabinet Minister whose policy decisions on income trusts were based on financial myths? Despite rave reviews from the Globe & Mail, couldn’t one definitely question whether Canada’s tiny perfect Finance Minister is the sharpest blade in Ottawa?

Additionally, do we really want the fate of some of Canada’s most valuable Western oil-patch reserves depending upon the alleged expertise of Ottawa bureaucrats who couldn’t distinguish a productive energy holding from an expense-account lunch chit?

And what would you think of a national leader who encouraged his Members of Parliament to defend his government’s flawed decision making with fabrications that would make the late Richard Nixon blush?

Rona, where are you, Rona? Rona?

Er, did we tell you about the latest eco-environmental initiatives that John Baird has implemented in the Prime Minister’s executive washroom?