Changes to the Taxation of Income Trusts

Flow-through entities such as income trusts have generally been considered tax-effective investments, as income earned in the trust could be flowed-through to investors free of tax at the trust level. Investors of the trust would pay tax on the income based on their personal tax rates. This was in contrast to income earned in a corporation, which would be taxed first at the corporate level, and then again as a dividend when paid to shareholders. This created inefficiencies in investing through income trusts versus corporations, as the combined corporate and personal taxes payable in the case of the latter would often exceed taxes payable in the income trust scenario. Recognizing these inefficiencies, many corporations have converted (or announced an intent to convert) to an income trust with the goal of obtaining a tax advantage.

In an attempt to eliminate the above inefficiencies, the 2006 federal budget proposed to uphold legislation originally introduced in November 2005. The legislation proposed a decrease in the taxation of dividends from eligible Canadian corporations, and by 2010, would ensure that taxes paid on corporate income would equal taxes paid on income earned through an income trust.

While the above changes are expected to balance out the taxation of trust and corporate income paid to Canadian taxable residents, two major issues were still present:

the government was still in a position to lose revenues as tax-exempt investors (investors that are not immediately subject to tax such as RPPs, RRSPs and RRIFs) were able to invest in non-taxable income trusts and defer tax indefinitely because of their tax-deferred status

non-resident investors could invest in Canadian income trusts, and subject the trust’s income to non-resident withholding rates as opposed to higher corporate tax rates

Both of the above scenarios created the potential for lost revenues on both the federal and provincial levels.

To address these concerns, Tuesday’s announcement proposes a new two-tier tax on distributions paid from an income trust. The distribution would be taxed first at the trust level, and then at the unitholder level as an eligible Canadian dividend. The dividend would be eligible for gross-up and enhanced dividend tax credit treatment.

To illustrate the net tax effect of this change, an analysis of three types of investors is necessary.

1)      Taxable Canadian Investors

*Rates are applicable as of 2011 when all corporate tax rate reductions are effective. Chart also assumes all provinces will adjust their dividend tax credits in step with proposed federal changes.

From a net tax perspective, apart from a slight decrease in rate (0.5%), Tuesday’s announcement has no impact on income trust distributions paid to taxable Canadian investors.

 2)      Tax-exempt Investors (RPPs, RRSPs, RRIFs)

*Rates are applicable as of 2011 when all corporate tax rate reductions are effective. Chart also assumes all provinces will adjust their dividend tax credits in step with proposed federal changes.

This is where the most dramatic change is found. Where non-taxable investors such as Canadian pension plans, RRSPs and RRIFs previously received income trust distributions free from taxation at both the trust and registered plan level, the distributions will now be taxed at the trust level before being paid to the tax-sheltered plan. This will ensure that both federal and provincial governments will receive some tax in the year the income is earned as opposed to indefinite deferral through the registered plan.

 3)      Taxable Non-resident Investors (US in this case)

*Rates are applicable as of 2011 when all corporate tax rate reductions are effective. Chart also assumes all provinces will adjust their dividend tax credits in step with proposed federal changes.

 Non-resident income trust investors will now be subject to tax on trust income similar to rates applicable to corporate income.  The actual non-resident withholding tax rate will be the rate applicable to Canadian dividends, and when combined with the tax payable at the trust level, the result will be government revenues of 41.5%. This is in contrast to a rate of 15%. In addition, the provinces will see increased revenues from this change as they will now be entitled to taxes collected in respect of the trust – something they do not benefit from when taxes are levied on the non-resident investor level only.

For trusts that begin trading publicly after October 2006, the effective date for taxation of distributions will be the 2007 taxation year. For trusts that are already publicly-traded, the new rules will take effect in 2011. This will allow a transitional period for appropriate adjustments to be made.

REITs will normally be excluded from the new rules subject to the nature of their income and investments.

What does this mean for income trust investors?

It depends on the type of investor. For taxable Canadian investors, there is no real change. With the exception of a 0.5% tax reduction, the net amount of tax collected (entity level plus investor level) will still be the same. There will, however, be some administrative differences as investors will now receive dividend income as opposed to business/other income.

Distributions to tax-exempt investors will now likely be reduced in lieu of tax payable at the trust level. That said, apart from the amount of the distribution, the change will impact the income trust, not the RPP, RRSP or RRIF. The registered plan will remain tax-sheltered, and amounts received will not be taxed at the plan level until later withdrawn from the plan.

Like tax-exempt investors, taxable non-resident income trust investors will likely see a reduction in their distributions to account for taxes paid at the trust level. However, the investor may also realize some benefit if an existing treaty with their country of residence allows for preferred withholding tax rates on dividends as opposed to trust income.

Other Changes

In addition to the above changes, Tuesday’s announcement included the following unrelated proposals.

·        Increase to age credit

The age credit is a non-refundable tax credit available to low and middle income seniors. For 2006, the claimable amount is $4,066, which produces federal tax savings of approximately $620. Tuesday’s announcement proposes to increase the amount by $1000 to $5,066, allowing for increased tax savings of up to $152.50. If approved, the change will tax effect January 1, 2006.

·        New pension income splitting opportunity

Effective 2007, Canadian residents eligible to claim the pension income amount (a non-refundable tax credit available in respect of certain pension incomes), will be permitted to report the taxable income on their spouse’s tax return. This creates an income splitting opportunity and possible reduction in the family’s tax payable. For individuals aged 65 years and over, eligible pension incomes generally include lifetime annuity payments under an RPP and payments out of or under a registered retirement income fund. For individuals under 65, eligible pension incomes include lifetime annuity payments under an RPP and certain other payments received as a result of death of a spouse or common-law partner.