Editorial: Feds’ closing of tax loophole long overdue

More than a few Canadian investors were a little distracted handing out candy at the front door on Halloween, eager as they were to head back to the TV to take in news that Canadian Finance Minister Jim Flaherty had decisively moved to rein in the income-trust sector.

For our many foreign readers, a quick backgrounder: Canadian income trusts use a corporate structure that’s essentially a huge tax loophole, allowing a company to virtually cease paying taxes and instead pay out most of its profits to its unitholders, leaving little money behind for management to reinvest in the business. The U.S. and Australia have already phased out similar corporate structures.

Originally conceived as a way to give a tax break to companies exploiting nearly depleted oil and gas wells in Western Canada, the trust-unit sector has ballooned from a total market capitalization of $18 billion at the end of 2000 to over $200 billion in October 2006.

In recent years, trusts have been popular with the retail crowd in Canada, especially seniors who like the trusts’ trademark monthly payouts.

It’s been widely reported that plans by telecom giants Telus and BCE, as well as oil and gas major Encana, to convert themselves into trusts pushed Flaherty to take action before even more tax revenue was lost to the federal coffers.

Flaherty’s new “Tax Fairness Plan” calls for income trusts to be treated as regular corporations, with existing trusts given until 2011 to adapt to the changes.

“Our plan is the result of months of careful consideration and evaluation. Our actions are clear, decisive and in the best interests of all Canadians,” said Flaherty in his announcement.

In particular, he emphasized that while the income-trust structure offers converting corporations short-term tax benefits, they are creating an economic distortion that is threatening Canada’s long-term economic growth and shifting any future tax burden onto hardworking individuals and families.

Flaherty’s right, of course, but he somehow forgot to mention that his Conservative Party had goofed in the first place by pandering to seniors during the federal election in January and promising not to raise taxes on income trusts.

The first trading day after Flaherty’s announcement, the 250 or so trust units trading on the TSX and TSX Venture Exchange plunged on average about 15%, lopping some $30 billion out of the sector, and dragging down the wider market — which completely recovered within a few days.

The loonie also dipped a half-cent against the greenback before quickly regaining its loss.

The mining sector was largely spared the carnage and Canada’s miners will only benefit by not having to unfairly subsidize other industrial sectors in Canada that widely use the trust-unit structure.

Indeed, there are only three mining-related trust units: the Labrador Iron Ore Royalty Income Fund with its, yes, iron ore assets in Labrador; the Noranda Income Trust Fund, which runs a zinc processing plant near Montreal; and the Fording Canadian Coal Trust, with its 60% interest in the Elk Valley Coal Partnership in Western Canada.

The damage to unit prices wrought by the announcement was painful for these three but not especially severe, particularly compared to the mining sector’s typical volatility: the Labrador fund slipped from $26.27 to $24.99 (or 5%) at presstime; the Noranda fund plummeted from $11.70 to $9.51 (or 19%); and Fording fell from $28.68 to $24.01 (or 9%).

The Canadian Association of Income Funds (CAIF) embarrassed itself by issuing some hysteric statements, including the improbable charge that Flaherty had caused a “devastating impact on this country’s economy.”

The CAIF argued that alternative options could have included increasing the withholding tax on income trusts and phasing in the tax on trusts over a decade as the U.S. government did.

The pro-trust arguments from seniors came across as small-minded. After helping to elect and re-elect high-taxing socialist governments decade in and decade out since the 1960s, Canada’s seniors now want to wash their hands of the damage they’ve done to the country and skip out on paying the bill for their folly? You’d hope aging would bring more wisdom than that.

Howls of outrage from the Bay Street crowd also rang hollow. These folks have made fortunes in recent years dressing up sometimes moribund companies and then spinning them off as trusts units. They got greedy, pushed the trust-conversion game too far, and will just have to move on to the next Big Thing.