Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 16 - Evidence - Meeting of September 28, 2005
OTTAWA, Wednesday, September 28, 2005
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:12 p.m. to examine and report upon the present state of the domestic and international financial system.
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: Ladies and gentlemen, welcome. We are about to embark on a most interesting but short hearing on the important issue of flow-through entities, based on our general terms of reference related to the present state of the domestic and international financial system. We have general terms of reference to deal with these matters, and we thank all the witnesses for coming today on such short notice.
These hearings occur at the same time that the Department of Finance is involved in a consultation process on income trusts and other flow-through entities, which was announced, I believe, earlier this month, on September 8. We have a copy of that press release available for senators, guests and the audience.
As well, there was an announcement on September 19 that advance rulings respecting flow-through entity structures will not be issued while the consultations are under way and until the government announces what actions it may take. In announcing the postponement of the advance tax rulings, Minister Goodale stated that consultations were launched because of the concern that the increased use of this type of business vehicle may affect economic growth.
This committee has a long history of examining policies, programs and other initiatives that affect economic growth in this country, and it supports the thesis that high economic growth and productivity lead to the prosperity that we all want. Minister Goodale also said he wants “to ensure that government tax revenues are appropriately safeguarded.” He wants “strong and vibrant Canadian enterprises of all sizes in all sectors contributing to a dynamic and growing economy.” Certainly, this committee similarly supports safeguarding tax revenues within the context of a fair, efficient and transparent tax system, as well as strong and vibrant companies and business firms that contribute to a dynamic and growing Canadian economy.
Through its hearings, the committee hopes to assist the current federal consultation process on this important issue of economic and fiscal implications of flow-through entities. We understand that these entities have experienced phenomenal growth in recent years, but there are certain concerns that we believe should be properly examined. Like the government, we want the discussions today and tomorrow to be transparent, constructive, balanced and, hopefully, fruitful. We understand that the announcements this month have caused some controversy and disruption for some companies and investors. However, we hope that our deliberations will bring balance and consideration to this important topic. We expect that once the public consultations have ended in December 2005, as announced, the government will indicate how it intends to proceed. Obviously, it is up to the government in terms of when and how.
We hope that the hearings broadcast today on CPAC and on the World Wide Web will bring greater clarity and balance to this complex area. Some clarity might be useful in indicating the nature of the flow-through entities, particularly income trusts, the problems and challenges associated with them, and what useful changes might be made, if any. We also hope that this examination will leave everyone with a clearer and deeper understanding of not only income trusts, but also the corporate taxation system, the incentives and disincentives inherent in the current system, and more particularly, the side effects of and the implications for vibrant and growing business enterprises.
In essence, the current hearings are but one aspect of our taxation system. We believe that clarity in how the system works and how its various components interact will be gained over time. As always, the main objective of the Standing Senate Committee on Banking, Trade and Commerce is the health and prosperity of the Canadian economy as a whole and the measures needed to ensure that the economy is working in a productive and efficient manner.
I thank the Department of Finance for responding so promptly to our request. We are delighted to welcome Mr. Leonard Farber, General Director, Legislation, Tax Policy Branch. With him are Ms. Louise Levonian and Mr. Denis Normand.
Mr. Farber, we would like to have a half-hour discussion with you, followed by questions and answers.
Leonard L. Farber, General Director, Legislation, Tax Policy Branch, Department of Finance Canada: Honourable senators, thank you for taking an interest in this important issue and for taking the time to be here today. We are pleased that you have, in a way, commenced the consultations. This is the first public forum since the press release on the consultation paper on September 8. Senators are absolutely right in saying that these discussions are intended to be broadly based and transparent, with the intention of gaining third-party input on a number of questions relating to publicly listed flow-through entities and the corporate environment in which corporations operate. We will endeavour to provide some background information on the consultations and take you through some of the key elements of the paper. We will be happy to answer any questions that honourable senators have.
Before launching into some of the elements of the paper, I will say a few words about Minister Goodale's announcement on September 19, wherein he asked the Minister of National Revenue, the Honourable John McCallum, to postpone commodity advance rulings respecting flow-through entity structures, effective immediately at that time. It is important to say that that press release alone will not prejudice any conclusions that the consultative process will arrive at or will engage in. It was designed to ensure that people are aware of the consultation paper and that they take it seriously. It is also important to point out that it would be inappropriate for the government to issue advance tax rulings on matters currently being consulted on. While a major consultation process has been launched, it is important that rulings on issues to be debated be held in abeyance until at least some conclusions and recommendations come forward.
As honourable senators know, the advance ruling process is an administrative, not legal, process. Therefore, the Canada Revenue Agency will not rule in the context of what their opinions are with regard to the state of the law as it applies to particular fact situations on transactions brought to their attention. Honourable senators, the minister has indicated strongly, and the chairman stated thus in his opening comments, that he is encouraging the public to participate in the process; and this is the beginning of that process.
One of the vehicles that the consultation paper lays out is a process by which we have engaged the Canadian Tax Foundation in helping us organize symposia across the country. We hope they will take place in Toronto, out West and in other areas, with a view to ensuring that both tax professionals and business people, who have an interest in the topic and all its angles, will have an opportunity to present papers and engage in open debate and discussion on the merits of particular courses of action and on the flow-through entities vehicle, how it operates, its benefits, how it advances economic efficiency and how corporations operate within that environment. Within that overall process, we will be able to get the kind of information that will render conclusions to direct us in dealing with the major policy issues that these matters raise.
The consultations relate generally to all publicly traded flow-through entities and, in particular, business income trusts, energy trusts, real estate investment trusts and limited partnerships. Over the last 10 years, these publicly listed flow-through entities have gained popularity as investment vehicles. Business income trusts, in particular, are a more recent development in Canada than energy trusts and real estate investment trusts, REITs, which have existed since the early 1980s.
The issues for consideration can broadly be characterized under four general headings: First, the impact of their tax treatment on how businesses are organized in Canada; second, their impact on federal tax revenues; third, the role tax- exempt investors play in this market; and fourth, the impact of the tax treatment of flow-through entities on the Canadian economy.
Related to these four broad and general headings, the paper lays out five questions in order to frame the discussion that we intend to have take place between now and the end of the year.
These five general questions relate to issues such as: Does the tax advantage of flow-through entities relative to public corporations have a significant impact on how businesses are organized in Canada? Have flow-through entities had a significant impact on tax revenues? In that context, is there a potential for revenue losses to grow in the years to come as this market continues to develop? What impacts are flow-through entities having on investment decisions and the allocation of capital in Canada? Is the overall impact on the economy in that regard positive or negative? Given the important role that tax-exempt investors play in Canadian capital markets and could play in the flow-through entities market, what impact would this have on government revenues and economic efficiency? Overall, are there public policy concerns about flow-through entities and how the tax system influences their existence? If so, what action should be considered to address these concerns?
In that context, clearly the corporate sector and the integration of corporate tax and personal tax will play an interesting role in that discussion as well.
That, honourable senators, is a brief overview of how the consultations will be framed and how we will go about trying to collect information in order to do the analysis.
There are a number of important issues in this regard that we think important to lay out in terms of what the economic efficiencies are, some of the tax policy implications of the flow-through entities, what the growth of the flow- through entities market has been in recent years, and some of the international comparisons.
I know that time is limited. My colleagues will go through some of these important issues just to give you a flavour of what the paper is trying to lay out in the public domain in order to engage in these consultations.
With your permission, Mr. Chairman, I would like to turn the floor over to Louise Levonian to give you a brief overview of some of these issues.
Louise Levonian, Director, Business Income Tax Division, Tax Policy Branch, Department of Finance: Honourable senators, allow me to begin by providing some background and context to these discussions. As has been mentioned, market capitalization has grown significantly over the past several years. Total market capitalization was $118 billion at the end of 2004, up from $18 billion at the end of 2000, and market capitalization to the end of August is up to $170 billion.
I draw your attention to page 10 of the consultation paper, where there is a breakdown of the growth in different types of income trusts and limited partnerships. There is the growth in business income trusts, energy trusts, REITs and limited partnerships. You can see how the business income trusts have grown the most, relatively speaking.
We expect that this growth is likely to continue over the next short while, and there are a couple of factors to which I will draw your attention. There was a question of limited liability with respect to investors holding these income trust units. Provinces have actually taken actions to limit that liability. Alberta legislated changes in May 2005; Manitoba did so in June 2005; Ontario did so in December 2004; and Quebec has had such legislation in place since 1994.
In addition, Standard & Poors announced that certain income trusts and limited partnerships would be included in the S&P/TSX composite index by March 2006, although questions have been raised as to whether S&P will postpone that inclusion for the time being.
With respect to the tax policy implications related to flow-through entities, one of the factors contributing to the growth in the use of flow-through entities has been the ability of such vehicles to flow income through to investors so that income tax is not paid at the entity level. That is the key part of these entities.
This differs from the tax treatment of corporations and their shareholders, where tax is paid both at the corporate level and at the shareholder level when the income is distributed. In contrast, flow-through entities generally do not pay tax but do make distributions to investors, and depending on the taxability of the investor, the government can receive tax revenues at that point.
Most of the distributions made by flow-through entities are income in the hands of investors, although there are different types of distributions, such as capital gains and returns of capital.
I will now turn to the international experience to give a comparison with other countries.
Canada appears to be in a unique position in having experienced such rapid growth with some of these structures in recent years. Flow-through tax treatment is not new. It is available in other countries. Australia, the United Kingdom and the U.S. have flow-through entities. They are generally more restricted and taxed as corporations. For example, in the U.S., with some exceptions, flow-through entities are generally treated as corporations. In Australia, publicly listed vehicles similar to flow-through entities in Canada are generally treated as corporations. It is interesting and important to note that in Australia, however, there is full integration between the corporate and personal tax system, which reduces the incentive to convert to these types of entities.
The U.K. is exploring introducing a tax regime for REITs, but does not currently appear to have the same type of publicly listed flow-through entities that we have in Canada. One reason for this may be that there are more stringent regulatory requirements.
With respect to revenue impacts, one issue that has received much attention has been the loss of federal tax revenues. The department estimates that in 2004 there was a reduction in tax revenues collected of $300 million, so tax revenues were less than we would have collected had FTEs structures not existed in Canada.
On page 28 of our document you will see that the estimate of $300 million is broken down by the different types of entities: business, energy, REITs and limited partnerships. Business income trusts account for $120 million of the cost. Energy trusts account for $55 million, REITs for $80 million, and limited partnerships for $45 million.
This estimate was calculated by comparing the federal income tax paid under the corporate structure and the flow- through entities structure. With respect to the revenues collected under the corporate structure, corporate income taxes paid were taken into account. Income tax or withholding tax paid by shareholders was taken into account and income tax paid by third-party lenders on interest income was also taken into account.
Under the flow-through entities structure, the tax revenues included income tax paid, if any, by the operating entity; income tax paid by the investor; and again income tax paid by third-party lenders.
This estimate is very sensitive to certain parameters. In particular, the proportion of flow-through entities held by tax-exempt investors and the average federal corporate income tax rate are key factors. I draw your attention to table 6 on page 29, where we have a sensitivity analysis. That table shows the proportion of flow-through entities held by tax- exempt investors, and on the left-hand side is the corporate tax rate.
As you shift those, you can see how the revenue leakage, the revenue loss, changes, depending on which assumption is chosen. In the third column over, second row down, you see the $300-million estimate, which is the one that we think is reasonable based on the assumptions that we have used.
You can see from the table that an increase of one percentage point, for example, under the column of zero tax- exempt investors, increases the revenue leakage. It decreases the revenues that we would have gained under that scenario by about $130 million. Just the one-point difference has a huge implication for the revenue estimate. Looking at the percentage of FTEs held by tax-exempt investors, if you go from zero to 20 per cent, there is over a $200-million difference.
Just by way of explanation, the corporate tax rate that you see there is not the actual rate. It is the average corporate tax rate applied on earnings before interest, depreciation and amortization. It is the basis of the revenue collected and the rate applied to that as opposed to the rate applied to taxable income, which is the one that you would have in your mind — the federal rate of 21 per cent.
Senator Oliver: It is uneven, then?
Ms. Levonian: Yes. These take into account future taxes — that is, there may be future tax effects related to certain tax-exempt entities such as pension funds and RRSPs. However, we expect the annual impact of these to be relatively small.
The paper also touches on the fact that there are provincial tax revenue implications as well. There is the potential for provincial corporate tax bases to shift. There is a potential for revenue leakage for provincial governments.
In particular, there is an interesting aspect of the shifting of the tax base for the provinces. For example, if a corporation hives off a certain part of their assets in a particular province, the corporate tax base will be lost or reduced significantly. Depending on where the investors are, that is where the tax base moves to. There is an interesting element of shifting the tax base where the provinces are concerned.
Finally, let me turn to one of the issues that Mr. Farber mentioned that is of significant importance to us, economic efficiency.
Given that the tax system may be a factor in the decision as to whether an FTE will be used to structure a particular business, it is important to determine what effect this has on the Canadian economy. Arguments have been made on both sides of this issue. Some have argued that the tax treatment of flow-through entities leads to greater economic efficiencies. Others have argued that the tax treatment distorts investment decisions and leads to reduced economic efficiency.
On the positive side, flow-through entities may remove an impediment to distribution of earnings. It has been argued that since business managers may face more limited reinvestment options than shareholders, it may be preferable that returns be distributed to investors, especially when the cash flows are generated by highly mature businesses with little potential growth.
Flow-through entities may also promote efficiency by providing a large pool of potential investors from mature business assets, and flow-through entities provide a financing option for corporations to reduce debt and restructure balance sheets by transferring income-generating assets.
On the other hand, the tax system could be driving decisions on how businesses structure themselves that could lead to inefficiencies. This could occur, for example, if businesses converted to an FTE structure before they have reached a mature stage — for example, during the business's innovation or growth stage. Arguments have been made that it would be difficult for a trust to attract capital for R&D, for example. Those arguments are out there.
In addition, distribution of cash flows to investors may not result in efficiency gains if shareholders do not have perfect information on which to make those decisions. Returning to capital markets with secondary offerings could be more costly than funding growth through retained earnings. Also, mature businesses using the corporate structure may be at a disadvantage compared to those operating in flow-through entities, so there is a fairness or competitiveness argument. To the extent that certain mature corporations may face barriers that prevent them from effectively using a flow-through entity, concerns of unfair competition may be raised. Finally, it has been argued that economic inefficiency may also occur if the flow-through entities structure favours investment in low-growth industries.
Mr. Farber: As you can see, Mr. Chairman, these are not easy issues. They span a range of concerns with regard to economic efficiency, capitalization, the merit of one structure over another and whether the tax system itself actually determines in what structure you will carry on your business. These are the kind of issues on which I think it will be important to get input, and we look forward to the consultations that will be engaged in. We certainly look forward to this committee being an integral part of it, and we thank you for that. We have had a long relationship with this committee, and we think this kind of setup can only foster the gathering of information that will be important in rendering the conclusions and recommendations that we hope will come out of this process.
We are certainly prepared to take whatever questions honourable senators may have with regard to what we have discussed.
The Chairman: Thank you very much for your opening statement.
Senator Angus and I have a common interest in a strong and productive economy. We sometimes come at the subject matter differently. He would like to make a brief opening statement, if you do not mind, and then he will be the first one to provide some questions.
Senator Angus: Thank you, chairman. There are three things that I would undertake to do.
First, for the record, I should like to make the following statement in connection with the new conflict of interest code for senators that has been adopted in the course of the summer and is now in effect. I wish to state that at the inception of this hearing, I filed with the clerk, with a copy to the chairman, a written declaration of a private interest pursuant to article 14 of the conflict of interest code for senators in which I have stated, inter alia, that I have reasonable grounds to believe that I may have a private, albeit an indirect, interest that might be affected by these hearings on income trusts. The general nature of this interest is my partnership at the law firm Stikeman Elliott. I have appended a letter to that declaration that, in effect, outlines the fact that although Stikeman Elliott has an active practice in income trusts and clients who may or may not be affected by what this committee may or may not find or what might transpire here, I have had no personal involvement whatsoever with that practice or any of the clients; that the hearings that we have called for today were in no way whatsoever, insofar as I was concerned, related to my partnership at Stikeman Elliott, but rather to my capacity as a senator and as the deputy chairman of this committee with an interest in fulfilling our ongoing mandate concerning the health of the Canadian financial system.
The declaration I just made orally is in conformity with section 15 of the conflict of interest code. I would ask the chairman and the clerk to ensure that all of the small minutiae of conformity are followed up on.
The Chairman: I will confirm we have received a larger document from Senator Angus pursuant to the rules. I thank him for that.
Senator Angus: Second, I would like to thank our friends from Finance Canada for being here today — and all those folks who are here to listen to and participate in these hearings, as well as all of you out there in CPAC land who we know are faithful followers of the deliberations that we conduct here at this committee.
I want to, not take issue, necessarily, with the opening statement that my colleague, Senator Grafstein, made, but perhaps amplify it. We do have an ongoing mandate to oversee the integrity and the stability of the financial system. In this regard, we are well aware of the discussion paper and it was our intention to participate in your deliberations in the fullness of time.
However, in the short period following September 8, as the record now will clearly show, income trusts have become the flavour of the month. You followed it up with a statement about a moratorium on advance tax rulings and this threw the marketplace into apparent — I do not like words like “disarray” or “turmoil,” but let us say uncertainty.
One of the direct results was an immediate meltdown of market cap in income trusts, we are told — we were simply told that and we read that — of up to $9 billion. The chairman and I and the steering committee of this committee felt we could not wait any longer to participate in your hearings; that this is a matter of grave concern to the financial markets here in Canada and how they are organized. That is why we, in your minds, may have jumped the gun, but we are here now and hopefully we can get some clarity.
Our ongoing understanding as members of this Standing Senate Committee on Banking, Trade and Commerce is that clarity is important for markets to function in an orderly manner. When there is great uncertainty, this is a recipe for disaster.
I am sure everybody in the room is ad idem with me on that. I wanted to add that appendage to Senator Grafstein's opening, if that is all right. Do you have anything to comment on there, Senator Grafstein?
The Chairman: You will see that this is a robust and vibrant committee and we can look at the same question in somewhat of a different way. The senator has his views. I have given you my statement; but at the end of the day we are both targeting the same result, which is to improve the productivity and efficiency of the marketplace.
I will let Senator Angus open with his first question.
Senator Angus: I address my question to you folks from the Department of Finance collectively. I know Mr. Farber; I am led to believe you are the driving force. I think everybody needs to know or should know that the minister, Mr. Goodale, was offered an opportunity to come here today. We apprised him of the fact that we would be holding these rather exceptional hearings, being this is the first day back. He is not here but he has an open invitation and I do believe he will come to discuss with us his views on financial system matters in the near future.
The Chairman: I think I should amplify what Senator Angus has said. Indeed, we asked him if he chose to come. We did not insist. We were quite concerned that we have the facts as best as you have now presented them on behalf of the government. The minister will have an opportunity. Later in the fall we will be hearing from the governor of the bank, and we hope after that we will hear from the minister. That will allow him an opportunity to come and reflect on what we have said today; and our recommendations, if any, will follow. I think we will have an ample opportunity to hear from the minister in due course.
Senator Angus: The sweetness and light of my earlier comments should be deemed to be continuing. However, I may have to phrase this question in a way that I hope you will not find improper or out of line.
It has to do with the process. Because of what appears to be a fairly substantial change in a period of just over a week, what was the underlying process within your department that led to the freeze on advance rulings?
The minister issued the consultation paper only 11 days prior to this freeze, which was fine. The markets were functioning and the participants and the stakeholders were carrying on their business in the knowledge that this process was unfolding. What happened within the department between September 8 and 19? What was the specific trigger? When was the decision made and who was present from the department? Perhaps this could provide some clarity as to what you folks are thinking and what happened.
Mr. Farber: There has been a process since March 2004, when the government first announced some limited intervention into the flow-through share area with some limitations on pension funds. At that point, that was part of the budget process and there were some fairly strong submissions made that there had been an inadequate degree of consultation. The submission was that the intervention on the pension funds was inappropriate and the government would benefit from some consultation. Therefore, at that time the government did announce a suspension of those rules, pending further consultation and the development of a consultation paper to get some public input.
In the interim between then and the following year's budget in February 2005, the government introduced another major measure with regard to foreign property limitations, removing all foreign property limitations with regard to the tax-exempt sector and what they could invest in. Again, the dynamic of the flow-through entity market then changed because it was not just the business income trust, but basically all flow-through entities, including limited partnerships. During that process, the paper was continuing to be developed.
That paper was finally issued on September 8, but not outside an environment where we had been holding some discussions and consultations with the sector generally without the benefit of the paper being in place. In the aftermath of that paper going out, I think you are right, nothing seemed to have occurred. In fact, I think the paper was almost dismissed as something that the government had laid out and it was not taken very seriously. You continued to see articles about potential corporate conversions and everything was occurring as if nothing had really taken place.
As I said in my opening remarks, senator, the rulings process is an administrative one; it is not based in law. It is not a legal type of process. It is merely a statement by the Canada Revenue Agency of how they will interpret the law against the background of a particular fact situation. It is binding provided the transaction is undertaken in exactly the way that the ruling has been issued.
The Chairman: It is case by case.
Mr. Farber: Yes.
The Chairman: It is somewhat like a law case, but it is limited to the facts at hand as provided by the applicant; is that correct?
Mr. Farber: That is right.
Senator Angus: Not only that, I think it is fair to say it is not necessary to have an advance ruling.
Mr. Farber: That was my next point.
Senator Angus: There you go; we are ad idem here. We are looking for the trigger, though.
The Chairman: We had better be more careful here; we cannot agree all the time, so let us have a little more balance.
Mr. Farber: I will try to be more careful, Mr. Chairman.
The honourable senator is exactly right; it is not necessary. In fact, there have been widespread reports in the press that for the vast majority of the publicly listed income trusts and energy trusts, no such rulings were ever sought. In that context, it is an interesting question as to what the impact is of a moratorium on rulings when rulings are, first, not necessary to conduct business; and, second, in many circumstances — I would not say most because I am not aware of them all — I am given to understand through public reports that very few rulings in this area have been sought. There have been rulings sought once a conversion had taken place and for some aspects within the income trust, but not for the conversions themselves. Therefore, in some ways, this ought not to have an impact. In many respects one might —
Senator Angus: Why did you do it?
Mr. Farber: One might look at it as a delayed reaction as well because the paper fundamentally lays out these important issues and what the government intends to discuss and consult on. The paper lays out the framework for how the process will be conducted. The issues go to the heart of how corporations are capitalized, why flow-through entities are used as a structure of choice, and what it is all about. As my colleague has indicated, in looking at some of those international comparisons, it is clear that many other countries have studied this and have taken certain actions.
I think the paper itself ought to have had, not a kind of reaction, but to have been a kind of indication that the government is serious about this issue. The government has taken its time in developing the paper, which, I might suggest, is neutral in its context. It attempts to lay out the issues in a neutral, balanced and, hopefully, transparent way so that the discussion and consultation will take place in a forum where everyone's views can be heard, no matter what side of the equation they are on. We certainly heard from all sides.
Senator Angus: Mr. Farber, my question was not that complicated. I am hearing in your answer, and I say this with total respect for you and your colleagues and what you are trying to do here, that because there was no real reaction to the paper, a decision was made to rattle the cage, if you like. My question is what happened between September 8 and September 19 to trigger the moratorium? Were there a lot of new applications? Was there new information? Whatever it was, it threw the street, the market, into uncertainty. That is our concern and we are trying to obtain information in these hearings that might calm the waters a little.
One of our understandings, and this is simplistic, is that in a sustained period of low interest rates, normal paper, such as fixed-income producing instruments, were not providing the kind of revenue people like poor senators on a fixed income needed. They needed a higher return on investment, if you will. Therefore, the income trusts were conceived of and, indeed, given birth to. You have elaborated on the numbers and this extraordinary growth in market cap. They found their way into these pension funds or RRSPs, where the return on investment doubled because of the tax-free status within those investments. Suddenly, with the meltdown of last week, all the savings of these poor ladies with blue hair and running shoes have evaporated. I am speaking of only a sampling of the email complaints I have received in Conservative Party offices in the last week. We want an answer.
Mr. Farber: First, the immediate reaction has, to a significant degree, been recovered from. What happened the day or two after the press release announcing the moratorium has been recovered from by more than 50 per cent. In that context, I think there is more of a rationalization as to what it was all about.
Senator Angus: You do not think the bankruptcies or the CCAA filings of some funds or trusts are related? It is just collateral damage, as they say?
Mr. Farber: As I said before, the reaction would have been there eventually anyway. What caused the reaction to occur quickly, I believe, is that the paper was issued, and within the next several days there seemed to be continual headlines about more and more trust conversions, as if the paper had not existed, as if no consultation process was taking place. In that context, it was clear that the government ought not to be ruling on or giving the Queen's blessing to transactions during a period when it had launched consultations.
Senator Angus: Are you referring to you folks? Did it occur to you people in the Department of Finance, or did this come down from Mr. Goodale?
Mr. Farber: It refers to the department. When Mr. Goodale appears, he will speak for himself.
It certainly occurred to the department that in the context of a consultation paper and the transactions that seemed to be going ahead, it would be inappropriate to rule on those kinds of things. It is not an appropriate mechanism. An administrative mechanism that had been in place has been suspended pending a conclusion. That does not mean that these transactions cannot go ahead. It also does not mean that at the end of the consultations these transactions will not benefit from an advance ruling at the appropriate time, but not during the period that the government is looking to consult with interested stakeholders on the wide ambit of what these issues are all about.
Senator Angus: That is a good start.
[Translation]
Senator Hervieux-Payette: It is my understanding that, in general, the people at stake here are those who own units in pension funds or stock saving plans, or who have started to live off the earnings generated by their investments. Amongst these unit holders are Canadians who are not experts and who bought their units through a broker in good faith; however, when it comes to distributing the income, we are being told that all of these people will receive less money, if we revert to the former system. Was a particular objective being sought when it was first decided to introduce income trusts and tax them in the way they are currently taxed? You spoke earlier of real estate investment trusts and resource royalty trusts, but mention has also been made of communication companies, banks, and indeed any old company, companies which do not necessarily offer consistent performance and revenue year in or year out, operating as income trusts. We have seen the high-profit communication companies undergo real slumps.
What happens to your average retired Canadian within the context of such a system? Will his income automatically drop? Will the value of his unit automatically drop? Is his capital protected?
[English]
The Chairman: That is a question.
Mr. Farber: Mr. Chair, with regard to senior citizens depending on cash-flow distributions on a monthly basis, frankly, those distributions that were occurring the month before the announcement are occurring the month after the announcement. The rate or the amount of distribution, by and large, is the same, unless something happens within the fund to warrant a change in the level of distribution. What actually changes is the rate of distribution on the capital value at that point. It goes up or down with the value of the unit on the market. For senior citizens looking for cash flow and income distribution on a monthly basis, nothing has really transpired. The value of the unit might fluctuate, just as the common share of a public company may fluctuate, depending on a host of different things, including interest rates, but the monthly distribution has not changed.
Senator Harb: I will get to the point. I think you are doing the right thing. I wanted to ask a specific question about the consultations and the suspensions.
On page 4, when you talk about a growth of $118 billion, you talk about the tax revenue impact, stating, on page 5, that the federal tax revenues in 2004 were $300 million lower than they would have been if FTEs were structured as corporations. Is it true that if they were treated as corporations they would still have the revenue of $118 billion?
Ms. Levonian: I am not sure I understand.
Senator Harb: Is the $300 million based on the assumption that the total market capitalization of $118 billion in that industry would remain the same if they were treated as corporations? There will be absolutely no evaporation; no one will quit; they will continue to have the same value? Is that your assumption?
Ms. Levonian: It is actually not based on the capitalization of the corporations or the FTEs; it is based on earnings. The entire model that comes up with the revenue estimates is based on the earnings before interest, so it is not the market capitalization of a corporation or of the trust itself, but of the earnings.
Senator Harb: That is exactly my point. You are assuming that these corporations will continue to operate and have the same kind of earnings.
Ms. Levonian: Yes, the earnings would remain the same.
Senator Harb: In the past four years we have seen a tremendous amount of growth in Canada in this sector. What has growth been like in Australia and the U.S.?
Ms. Levonian: Australia has a fully integrated tax system and taxes these types of flow-through entities as corporations. Although I do not have the actual data, I do not expect that there has been growth in Australia, given the circumstances there.
What is developing in the U.S. is interesting. Different types of entities are popping up that are similar. There are entities called income deposit securities that are, in essence, equity and debt stapled together, mimicking what an income trust would do.
The Chairman: It is a new instrument not unlike a bond of a very specialized nature. We are not sure where that is going, but the Americans are always very adept at coming up with a new instrument to fit a specific course. However, there is a taxation implication to that that does not exist in Canada, is there not?
Ms Levonian: For those types of entities in Canada?
The Chairman: Yes. Do a comparison between the two.
Ms. Levonian: They are similar in nature, because income trusts put together the debt and the equity.
The Chairman: What would be the tax implications of that instrument compared to income trusts here?
Ms. Levonian: It is similar.
The Chairman: Thank you.
Ms. Levonian: The U.S. is experiencing some evolution of those kinds of things as well, although not to the extent that Canada has.
Senator Harb: I presume these entities are open to outside investors, as we live in a global economy.
Have you done an analysis of tax implications of outside investors repatriating their money with regard to withholding tax? Would that mean a total escape of that money from Canada? If you were to change things around, that money would probably go elsewhere.
Ms. Levonian: Are you talking about when a U.S. investor invests in Canada and then repatriates the money?
Senator Harb: Yes.
Ms. Levonian: The general answer is that there are withholding taxes for cross-border payments. Generally speaking, they are 15 per cent applied to interest. In the 2004 budget, we introduced new measures to, in essence, tax capital gains flowing to the U.S. as well. Therefore, there is some protection in our Canadian system to capture the tax revenues that are generated in Canada.
Mr. Farber: Since you cannot always distinguish between the capital and the income element because they are just cash contributions, we withhold on the entire payment and allow for a reconciliation within four years. If there is a disposition, you could make an adjustment to the cost base and reduce the ultimate capital gain, but we tax the distribution.
Senator Oliver: It is my impression that the main thing you are after in this study is business income trusts. I know there are REITs, royalty trusts and all kinds of other flow-through mechanisms that have been around for decades, but my impression from what you have said today is that the real culprit you are after is business income trusts. When I look at the numbers for the year 2004-05 on page 28 of your document, I see that the federal government earned about $30 billion in revenues from corporate income tax. You told us today that you think the loss from business income tax is only $120 million. It sounds as though you are going after a rabbit with an elephant gun, because $120 million is not very substantial compared to the revenue of $30 billion a year that you receive.
Do concerns about economic efficiency justify a major change in public policy and tax policy, or is your concern triggered by the ruminations of Gord Nixon at the RBC that if one bank does it, the others will?
Ms. Levonian: As to whether we are really after business income trusts, as my colleague was explaining, the 2004 budget announced particular measures to limit pension fund investment in business income trusts. Following that, the 2005 budget eliminated the foreign property rule. Limited partnerships were part of the foreign property rule, and when that was eliminated it opened up limited partnerships to being the same kind of entity as business income trusts. We are trying to consult. To say that business income trusts is what we are after would be to prejudge the outcome of the consultations. We wanted to look at flow-through entities in general and hear the perspective of all stakeholders on the different types of entities, and following the consultation we would make the necessary recommendations.
Senator Oliver: Can you comment on the comparison of $120 million to $30 billion in your revenues?
Ms. Levonian: I am sorry; I was not sure what you were referring to.
Senator Oliver: The gross revenue from corporation tax was $30 billion, and you have indicated that the total loss for all of these flow-throughs was about $300 million, and then you gave us a breakdown. You said that for business trusts it was $120 million. The factor of $120 million, which you project might be the loss from business income trusts, compared to a revenue of $30 billion seems a little like going after a rabbit with an elephant gun.
Ms. Levonian: I see exactly what you are saying. There are many factors to take into account when deciding on the appropriate action for these types of issues. As the minister said in the press release on September 19, revenue considerations are one concern, but the impact on the economy of corporations structuring in a way that is different from what we are accustomed to is an important factor in deciding where to go with respect to these entities.
Senator Oliver: When Gordon Nixon of the Royal Bank of Canada ruminated that he might spin some of the Royal Bank assets into an income trust, what effect did that have on the deliberations within your department?
Ms. Levonian: I would say that no one conversion would have an impact on our decision process going forward. We would take everything into consideration.
Senator Oliver: If that was the beginning of all the banks doing the same, would that be a consideration?
The Chairman: Senator Oliver, I think you have had an answer to that. You can get a further answer after the hearings, as we have time constraints.
[Translation]
Senator Plamondon: My question will be very simple, because I'm approaching the matter with a layman's perspective. According to the testimony that we have heard, there has been a phenomenal growth in this type of investment, and my question is, who is profiting the most? Is it the Government of Canada, which could reinvest what it reaps to help the average Canadian, or is it businesses and investors who gain the most?
[English]
Ms. Levonian: That is a difficult question to answer off the top of my head.
Senator Plamondon: Will it be business?
Ms. Levonian: Not necessarily. The company itself is owned by investors. At the end of the day, the investors are the ones who will benefit from it.
[Translation]
Senator Plamondon: For the investor to reap the most from this system, then somebody, somewhere has to be losing out. Who ends up losing the most?
You said that the Government of Canada loses money, and you recognized that this holds repercussions for the provinces. Have you scheduled consultations with the provinces? If it is the investor who benefits the most, who is it that loses the most?
[English]
Ms. Levonian: I would say that the loss in revenues is coming from governments. When a corporation converts to an income trust, there is always an increase in value. Some have argued that that increase is mostly attributed to the tax gain. The tax loss is coming from governments, federal and provincial.
[Translation]
Senator Plamondon: Would I be correct in saying that investors gain more than the average Canadian, as this system leaves the Government of Canada with less revenue to allocate?
Ms. Levonian: What do you mean by “the average Canadian”?
Senator Plamondon: The Government of Canada's revenue is shared amongst all Canadians; yet this system benefits investors, and not all Canadians are investors.
[English]
The Chairman: If you could give us your best response to that, then we will move on. We have worked this question over somewhat. It is an important question, but I think we must move on.
Ms. Levonian: Generally speaking, the federal government does its budgeting taking into consideration many factors. Many things affect government revenues; they go higher or lower, depending on such things as how the economy is doing. Would income trusts affect a particular program in a particular area? I would say no.
[Translation]
Senator Plamondon: The bottom line is that, in general, somebody is going to lose out.
[English]
The Chairman: I am not trying to cut off the discussion. Again, if you want to follow up, senator, and get your answer, they will be available immediately after the hearing.
Senator Moore: Just to carry on with Senator Plamondon's questioning, it is one thing to say that someone has won and someone has lost, but do not forget that Canadian individuals took a risk. They invested. Everybody is forgetting about the little guy who has put in some money. It is not like Big Brother is winning or losing. People have looked at a prospectus and decided they would invest their hard-earned money and hope for a gain. I do not see what is wrong. If people want to take a risk, put in their money and take a chance, it is their business.
Senator Angus: It is not like Treasury Board, with their 12 per cent.
Senator Moore: It is not; not at all.
I would like to get on record Senator Oliver's question with regard to the president of the Royal Bank of Canada. He indicated that they might possibly spin off one or two of their activities into a trust. Senator Oliver asked you if that comment would have spurred you to take action. You said no, not one person. What if all of the chartered banks did that, what would you be doing then?
Mr. Farber: It is a hypothetical question. I understand where you are coming from.
The Chairman: It is not a hypothetical question. The banks tend to behave in a domino-effect fashion.
Mr. Farber: I do understand that, Mr. Chairman. The banks are also a regulated industry. I am not sure that a bank by itself will say “I am doing this” and that is the end of the story. They are regulated and there is a process. What my colleague said in answer to the question was that there is no one thing that will stimulate a response, but a series of considerations. As I said earlier, in the aftermath of the release of the paper, there did not seem to be any attention paid to it. In the context of what was said, given that the rulings process is an administrative process — and I emphasize that — the government did not really take action per se, other than to say what was appropriate, that it would not give a blessing to transactions during the time that it is consulting on the issue.
The Chairman: I think it is fair to say, Mr. Farber, that the minister and you have got our attention, the taxpayers' attention and the investors' attention. You have accomplished your goal.
Mr. Farber: Absolutely. That is why this process is taking place as it is today. This kind of fruitful discussion is where we will get answers.
Senator Moore: It is fruitful, but at the same time I find it to be something of a prejudging. It is one thing to say we are doing a study and we will see what comes out of it and then we may take action, but to do that when people are going about their business in the marketplace is most unusual, I would say.
There was an interesting letter to the editor in the National Post last Saturday, September 24, saying that our finance ministry focuses entirely on the loss of corporate tax revenue but never on the millions more in capital gains taxes that they have received during this income trust boom, not to mention the GST from additional consumer spending due to the extra income generated in taxable accounts.
Getting back to the point, Senator Oliver mentioned that your target, if you will, is the business income trust. What about the other side? What about the taxes that have been generated as stated in that letter? Did you analyze that? How does that compare with the other numbers in your report?
The Chairman: That is a question.
Ms. Levonian: The answer to the question is on page 28 of the income trust paper. We actually did take into account the capital gains that result from conversions to an income trust. It is line 3 on table 5 that values the tax on conversion.
Senator Moore: Could you just read that?
Ms. Levonian: Tax on conversion, the total is $40 million. That factors into the $300-million estimate.
Senator Moore: The $40 million is the total that the treasury would have received from capital gains taxes on people trading in their units. Is that correct?
Ms. Levonian: From conversions.
Senator Moore: From conversions. You are talking about a corporation converting itself to an FTE. I am talking about people buying units, the value goes up, they make a gain and you are getting tax on that. Did you look at that?
Ms. Levonian: That is in lines 1 and 2 as well. Where you see the taxes under the flow-through structure and taxes under the corporate structure, capital gains are factored into those two numbers. Furthermore, conversion capital gains are factored in on line 3.
The Chairman: I have several brief questions. Please respond quickly. I apologize; we do have other witnesses and we will give them a little more leeway.
The staff has done some analysis for us. They took an operating business corporation that has a $100-million income. We then assume a $100 dividend to be distributed to investors vis-à-vis the corporate structure and the $100 vis-à-vis an income trust as interest payments. We went through the analysis. It is part of our briefing notes. We will make them available to you. At the end of the day, if you are in a corporate structure, the $100 ends up as $43 received by a shareholder, and as $54 by a unit holder of an income trust. There is obviously an apparent unfairness between two business firms, one using the normal corporate structure that we know, the other having moved to the income trust, and the end result is that the unit holder receives about $11 more, or 22 per cent, roughly. That strikes me as fundamentally unfair. That means there is confusion in the marketplace as to the intention of the tax system.
There might be two entities in the same business, one taking the unit route and the other the corporate route. What does the government want us to think about as we approach the tax system? Could you respond to that quickly?
Committee members have been concerned about productivity and we do not know the answer to the problem. I have read some press articles that say this is anecdotal. We discovered in our study on productivity that corporations in the United States invest $1,500 more per worker and, therefore, the productivity is higher. The question of the committee, consistent with its study, is what is the impact of an income trust in terms of its internal investment structure compared to the normal corporate structure? Have you analyzed that? The minister referred to that in his comments about the impact that this would have on productivity. Please help us on both of those. Please make it short, if possible, and if not, please send the answer in writing to the clerk of the committee.
Ms. Levonian: With respect to your first question, it is difficult to comment without seeing the analysis.
The Chairman: We will make it available to you, with my apologies.
Ms. Levonian: We have a similar analysis in the consultation paper on page 19.
The Chairman: Yes, it is parallel to that.
Ms. Levonian: I completely agree. You have highlighted nicely the two predominantly featured issues in the paper, one of which is the concern about the differential between a corporate structure and an income trust structure. From a tax perspective there is a clear lack of neutrality, and we wanted to highlight that in the paper, as you have done. In respect of productivity, I spoke to the economic efficiency angle at the end of my opening remarks. The productivity angle is the other major concern that we have about the restructuring of corporations as trusts, and that is precisely why we are consulting and wanting to hear from stakeholders.
Senator Moore: Is that in terms of reinvesting in plants?
The Chairman: Yes. The press has said, in response to the minister's statement, that this is anecdotal. One wise observer said that there is no evidence one way or the other that there is any differential. Can you provide us with any statistics or analysis to help us with our deliberations on this question? It is important to us because this committee is mandated to examine the Canadian economy with a mind to increasing productivity, which means increasing the standard of living of all Canadians. It is not an obsession with us but rather a principle. Can you help us with this as it applies to this particular paper?
Ms. Levonian: You said that there is no evidence, but a calculation can be done on the differential between the taxes paid.
The Chairman: We have done that.
Ms. Levonian: It is pretty clear that there is non-neutrality in the system.
The Chairman: However, will one structure more than the other induce entrepreneurial management to invest less in their ongoing enterprise as opposed to sending the money out to their shareholders or unitholders to invest in their own needs? The purpose of the corporation is to be productive and competitive and to create jobs, income and growth.
Ms. Levonian: Absolutely. That is one of the fundamental reasons we are consulting. We want to hear the stakeholders' perspectives, to know whether it is less or more inefficient to have this non-neutrality or whether it is removing an impediment. These are difficult things to nail down and to determine by statistical analysis. We would love to be able to quantify that question in some way, but it is a difficult.
The Chairman: We have to conclude, but in the course of the consultation, if you have any of that material we would like to see it.
Senator Angus: The advantages of living in the world of cybernetics include late-breaking news. As the markets closed today, the mutual fund giant CI Financial officially postponed its planned conversion to an income trust and blames the recent confusion created by the federal government's decision to effectively freeze new trusts. The CEO said that the government has painted a picture of income trusts as a problem that must be addressed. He said that given the negative business climate created by the federal government, they cannot recommend today to their shareholders that CI pursue an income trust structure. I understand this had to do with the conversion, as opposed to an IPO, and that a tax ruling was needed. I can anticipate what you might say. I promised that my question would be brief, and I hope your answer will be succinct. When Minister Goodale, subsequent to September 8 suggested that income trusts are a problem and suggested a negative business climate, is that the kind of result expected by the government? Was the minister advised that there was a potential for this meltdown in market cap and this kind of uncertainty in the marketplace? Is this something you anticipated?
Mr. Farber: Your instructions, Mr. Chairman, to keep it short are difficult under the particular circumstances. The paper came out on September 8 and laid out the broad ambit of what we wanted to discuss, and we have been discussing that today. They issues are complicated and important. I do not think anything we have said or done would prejudice any conclusions that may come out of the consultative process. I repeat what I said earlier: It would be inappropriate for the government to give an advance tax ruling on any particular transaction during this period. That is what it announced on September 19. As to the fact that the market has reacted in that way, one can only speculate about reaction. In respect of the meltdown that you are suggesting, senator, there was a downturn one or two days after the announcement but it has come back significantly. I can only speculate. If I could do more than that I might not be sitting here. As rational minds understand better what it is all about, the market will react appropriately.
Senator Angus: Nothing happened that you did not anticipate. You anticipated this.
Mr. Farber: You always anticipate some reaction. Yes, there are pros and cons to any advice that one would give the minister, as there would be for advice that we would give you.
The Chairman: We would love to speculate about and try to predict the market but, unfortunately, we cannot do that now. Thank you, Mr. Farber, Ms. Levonian and Mr. Normand. Forgive us for being a little brusque due to lack of time.
Our next witnesses are from the Canadian Association of Income Funds. We are trying to bring some clarity, understanding and balance to an important public debate, and we hope to do it in a way that does not rile the marketplace. We hope that in our exchange today we will be able to calm the waters. I would ask the witnesses to limit their remarks to 20 minutes. That will allow us more time for a spirited Q and A period. You will see that the senators are very interested in this topic. We are fully briefed and we are interested in what you have to say.
Again, thank you, and I apologize for the delay. Our time is limited but the topic is important.
Welcome again; perhaps you might introduce all of the witnesses, Mr. Probyn.
Stephen Probyn, President and CEO, Clean Power Income Fund, Canadian Association of Income Funds: Thank you very much, Mr. Chairman, and honourable senators. We are pleased to be here today on behalf of the Canadian Association of Income Funds. CAIF, as we call it, represents the Canadian income funds industry, including publicly listed income trusts, royalty trusts and limited partnerships.
I would like to introduce you to my associates in attendance today. George Kesteven is President of CAIF and director of investor relations with PrimeWest Energy Trust. Paul Hollands is CEO of A&W Revenue Royalties Income Fund. Marcel Coutu is the President and CEO of Canadian Oil Sands Trust. I am the Chair of CAIF and CEO of Clean Power Income Fund.
Our agenda is threefold today. We want to (1) provide you with background; (2) underline our role in the Canadian economy; and (3) address the Department of Finance's consultation process.
An income fund, whether a royalty trust, business income fund or REIT, is a form of legal business structure that is established and operates under all applicable federal and provincial laws. The businesses that underlie the trusts operate as any other business would in Canada, creating jobs, making investments and acting as good corporate citizens.
There are, however, some differences. In the case of a traditional corporate structure, the largest portion of revenues typically remains in the corporation and the board of directors determines what portion, if any, of after-tax profits will be distributed to shareholders as dividends.
The trust structure keeps a portion of its revenues for paying employees, paying suppliers and financing investments, but allows a larger proportion of the cash generated by the corporation's business activities to flow directly to the owners of individual units in the trust. Unit holders in income funds then receive regular — often monthly — payments of cash flow from the operations of the business, as detailed in the income fund's prospectus.
Income funds do not pay corporate tax in and of themselves. However, the monthly payments that flow to investors, or unit holders, are subject to taxation in their hands. This is a critical point, senators. The beneficiaries of the trust, the millions of Canadians who have invested in trust units, actually pay taxes at higher rates than do corporations.
There are approximately 220 individual trusts now listed on the Toronto Stock Exchange and the TSX Venture Exchange with a total market capitalization exceeding $176 billion.
The fundamental principle of income funds is that cash generated by a business is handed back to the businesses' owners, who are effectively the unit holders. Like the owners of any privately held business, our owners decide what to do with that cash. They can reinvest it in the business by buying more units as they are issued or through programs such as distribution reinvestment programs, also known as DRIPs. They can decide to diversify their investments. They can invest in their homes; they can spend the money to support themselves and their families, as do many Canadians across the country. This is the essence of ownership of units in an income fund.
Income funds are engaged in basic productive enterprises that drive our economy. For example, Mr. Kesteven is director of investor relations with PrimeWest Energy Trust, which has spent millions on a variety of secondary and tertiary recovery technologies to enhance the productivity of Canada's conventional oil and gas resources.
Mr. Coutu is the President and CEO of Canadian Oil Sands Trust, the largest shareholder in Syncrude, the largest oil sands extractor in the world. Since 2002, Canadian Oil Sands Trust has invested $2.8 billion in the stage-three development of the Syncrude project.
Mr. Hollands is the CEO of A&W Revenue Royalties Income Fund, which has franchised over 650 A&W restaurants and is one of the fastest growing chains in Canada. I will add that the Canadian A&W, which is in the hands of an income trust, is one of the best performing of that franchise in the world.
Finally, I would like to point out that in my case Clean Power Income Fund is investing some $186 million in the construction of one of Canada's largest wind energy facilities, the Erie Shores project.
We believe that income funds have demonstrated a substantial contribution to productivity and growth in Canada. CAIF has commissioned a major study on this subject, which will form part of our submission to the consultative process.
Income funds are well-managed organizations that run their business on the same principles of corporate governance as the corporate sector. We have high standards of disclosure and are subject to regulation by both the TSX and Canadian securities regulators. Many have commented that the discipline for management of distributing the bulk of cash generated by the business to its owners provides more rather than less accountability.
We know that 1 million Canadians across the country are direct owners of units and many more millions own units through mutual funds.
Over the past few days, we have been inundated by phone calls, letters, faxes and emails from individual Canadians who are frightened and worried.
I would like to share with you the thoughts expressed by one owner in particular, whom I will refer to as Mary. Mary writes:
My anger has subsided; now I fear for my future. I will try to rationally describe what I see as the problem for me, a 60 year old Canadian. The trust sector is the only option available to survive in this country as a retired person....
Mary goes on to describe how in the two days following the government's intervention on September 19, she lost $25,000 in the value of her RRSP. Continuing in Mary's words:
I have worked non stop for over 40 years, I am self-employed. Next year I must stop working. How will I support myself at age 61? Early CPP at about $550 a month is ridiculously insufficient. I have no company pension to rely on. All I have is my RRSP investment account...
My income trusts pay me about $28,000 a year in distributions, average yield of 8 per cent. These distributions include Income and Return of my own Capital in my sheltered account. I currently re-invest every penny I receive from investments. I no longer can afford to contribute to my RRSP account.
When I retire next year, you will tax me at my marginal rate, 26-to-30 per cent, depending on how well I do with my investments. So please tell me...where is this tax leakage? We pay higher taxes than the corporations...
Mary continues:
Income Trusts allow more retired Canadians to be financially independent, not wealthy but independent. This financial independence is all we look for and expect from this country...
I have paid my dues over 40 years of working. DON'T take my only means of survival away from me.
Yours truly,
“Mary.”
The subject of your hearings today is the government's current consultations with respect to the income fund industry. Let me say that we as an industry publicly applauded the manner in which the government launched this consultation exercise on September 8.
I would like to remind honourable senators that the Department of Finance stated:
The focus of the paper is to assess the tax and economic efficiency implications of [flow-through entities] to determine if the current tax system is appropriate or should be modified.
We believed at that time that the government was committed to an even-handed approach. However, we are less enthusiastic with recent developments.
Eleven days after the consultation paper was released on September 19, the government pre-empted its own consultation process by suspending advance tax rulings and creating market instability. As Senator Angus has noted, this led to a $9-billion loss in equity to Canadian investors.
This suggests a failure of the process, with the government undertaking to change policy and entirely circumvent its own consultation process. One day later, on September 20, Minister Emerson stated, “Ottawa needs to move quickly to change how income trusts are taxed...”
The clear implication of this statement is not if, but when. I remind you that that evolution in policy occurred between September 8 and September 20.
On behalf of our membership, CAIF hopes your committee will join us in returning to the process the spirit of genuine consultation and helping restore investor confidence in a legitimate consultative process as announced on September 8. The industry and individual investors need confidence in the process, and we ask the Senate of Canada for its assistance in this regard.
I would now like to pass it over to my colleague Mr. Kesteven, the President of CAIF, who will be pleased to field any questions you might have.
The Chairman: First I want to thank you very much, Mr. Probyn, for being so concise and pointed in your comments. I again welcome your initiative in terms of analyzing your corporate structures from a productivity standpoint, as I think you got our message that this is of concern to us. It is of concern to Mr. Greenspan in the United States. It is of concern to Mr. Dodge in Canada. We cannot fall behind in terms of productivity, so we will look at this study very carefully.
I want to thank your group for investing in this initiative because it will help us in our future work. We have just started the study on productivity. The government is taking it up. We now hear it is an almost repetitive word in the dialectic of the government. That is good as far as we are concerned. We are delighted that your group is doing the same thing.
Senator Angus: First, gentlemen, I reiterate the welcome and thank you for coming. I thought your paper was very concise, as the chairman has stated.
You were here in the room when the gentleman and lady from Finance spoke with us a little while ago. I think you were all here. Most of you were, anyway.
Is it not a fact that Mr. Farber was correct in stating that the integrity of Mary's capital has been more or less clawed back in the intervening period; or is that not the case?
Mr. Probyn: I have been in several discussions with Mary. I cannot reveal her surname because she was concerned about disclosing the information that she did. I can tell you that her view is that it has not come back. I do not know what her investment portfolio consists of.
She says she is very concerned about her future because she relies on this investment. She lives in Toronto, and as many senators know, it is not a cheap place to live.
Senator Angus: Obviously she is not from Montreal; otherwise, her name would be Marie.
What I am trying to figure out here — and your members are some of those people who have sent us many of these emails that I have held up before, which relate to Mr. Solberg and his questioning of Minister Emerson and Minister Goodale in the House of Commons — is what precisely are you folks suggesting? That is why we decided to have this almost extraordinary couple of days of hearings before the government's discussion process evolves.
Are you suggesting that those government hearings will be a sham, the die is cast and the government has a hidden agenda?
Mr. Probyn: We would like to get the hearings back on track. I was listening closely to Mr. Farber in his description of the process and, quite frankly, I would characterize that as somewhat cute, in the sense that there have been significant statements made by ministers. There have been back-channel discussions, all of which I think would lead any rational observer or investor such as Mary to believe that the outcome of the consultative process had been preordained.
We think there is an outstanding case for the trusts, and not just in terms of their impact on the investors, which is of course the most important aspect, but also on Canada. I would invite you to ask my colleagues sitting at this table about significant productivity gains that have been made in the context of trust investment. They are very important to our country as we seek to obtain leadership and to compete in the world.
Marcel R. Coutu, President and CEO, Canadian Oilsands; Canadian Association of Income Funds: I am here to answer your questions.
The Chairman: We are very familiar with your enterprise. I would like to hear the response to the question about our concern that this corporate organizational forum might stunt or defer or create disincentives for reinvestment in terms of productivity, and you are a perfect example. Tell us if we are right, wrong, or where we are on this. It might be interesting to hear from you as opposed to us.
Mr. Coutu: We are probably the best example, if you will, because we have not distributed a lot of cash, at least not in recent years.
Senator Angus: Canadian oil sands, trust me, are not making anything.
Mr. Coutu: The yield on our market price is less than 2 per cent. People hold us for what they believe is the ability to build value and get their return in the form of capital gains, and, in the fullness of time, a strong yield on top of that. We are working in that direction.
I do not think that whether assets are in a corporation or in a trust is the main reason why they may or may not grow or investments may or may not be made. I think it has more to do with, not the quality, but the nature of the assets. Some assets in and of themselves are in a mature state, and many have gravitated to income trusts. That is an efficient way for investors to make lower-risk investments with their capital. They are taking risks, and they will get back distributions, which are not all interest.
Generally these assets, particularly in the energy sector, are declining assets, so they are getting a lot of their capital back. You have to be careful about what you say is coming. Corporations do tend to try to grow, from a capital gains standpoint, and they would have greater difficulty, I think, in Canada in returning immediate gains on their investments through dividends. I would like to make a point about that at some time. I think, Mr. Chairman, you were going that way earlier. There is a big discrepancy there that I think is at the centre of this entire discussion.
In the case of Canadian Oilsands, and this is maybe what people want to hear a little about, we started life 10 years ago as a trust. We had a 12.5 per cent interest in Syncrude. We were IPOed with a market cap of about $270 million, $10 a unit, with the benefit of a market that was conducive to investing in our type of vehicle. We were never a big dividend or distribution payer.
The fact is that trust structures do attract capital at a cost that is somewhat lower than for corporations because our risk is deemed to be lower, and that is how we manage our business. Therefore, with a lower cost of capital, through one merger and two acquisitions, we find ourselves now owning 35 per cent of Syncrude, ahead of all the other owners, including the big players in the patch like Imperial and Coneco Phillips, et cetera. That advantage has made a big difference. This is not to say there are not other factors. That can still be the case.
The Chairman: I will interrupt because I am trying to follow this in my own mind. Are you telling us that, in your case, you have been able to obtain capital at a lower cost and therefore to improve your reinvestment ratios and move to more productive and modern technologies?
Mr. Coutu: The argument is that we are able to do that as well as corporations, which have other advantages.
The Chairman: You suggested something better, that is, that the income trust has attracted capital at a lower rate, which allows you to redeploy your capital on a more cost-effective basis than corporations, which pay higher taxes and have to attract capital at a higher rate. Is that your argument?
Mr. Coutu: There is some truth to that, yes. I agree with that.
We do not pay the distribution. We have an asset that can stand some development and a lot of capital. You have heard the number in the recent stage of expansion. Our share of the expenditures has been $2.8 billion. We will spend over $8 billion in this expansion. On top of that, we spend and invest on other fronts. We invest in research and development. Canadian Oilsands invests over $20 million in research and development every year. That is not to say that other trusts do not do that, but I can speak for ours. As well, we invest in sustaining capital. Generally, that is replacing equipment with more modern equipment, and our share of that spending is about $100 million a year.
There is a lot of investment going into your point about productivity. If you are running a business in a sound manner, you will create profits for your shareholders, which could be in the form of capital gains, most of which have been derived that way for Canadian Oilsands, and in the form of distributions for many others.
I will speak for some of the energy folks who are in a different business from ours. In some cases, it is tougher for them because they have short reserve lives. The wonderful thing that would be of interest to you is that because of this lower cost of capital, they are able to go after reservoirs that larger companies have walked away from. They apply new technologies to those reservoirs, such as CO2 floods, which may help us with the Kyoto Protocol. They use all types of state-of-the-art technology to extract even more resources. They do that because they have a lower cost of capital, so their economic threshold is much better.
Also germane to this argument is that, having built some capital in their organizations, their pay-out ratios have started to come down. They were paying out 100 per cent. They realized that they have to continue to invest in order to grow, or even survive, so now they are only paying out 60 or 70 per cent, and some even less than that; they are starting to look a lot more like E and P companies of the past.
Another real plus is the expertise and the calibre of the people involved. I come from the East, but I have been living in Calgary for 25 years. I am very impressed with the calibre of the people who have come from large corporations to dedicate their careers to these trusts. Now that they are getting a foothold, they are actually investing internationally. That is a great boon to Canada, because now they are buying assets that are generating revenue that they are bringing back to Canada for taxation here.
Senator Angus: You are seeing the concern of this committee about the relationship between our tax system and the competitiveness and productivity of the Canadian economy. The recent C.D. Howe Institute study, with which I believe you are familiar, entitled “2005 Tax Competitiveness Report: Unleashing the Canadian Tiger,” concludes that Canada had the second-highest effective tax rate on capital among 36 industrialized and leading developing countries.
This has led to various creative business arrangements, I understand. The best example of these financial distortions is the growth of the income trust market. I suggest that income trusts are a response to a tax system that discriminates against dividends as compared to other sources of income.
Is that correct? The marketplace has come up with these vehicles in the face of low interest rates and high taxes, and the masters here in Ottawa are saying that perhaps we are becoming competitive and productive with these vehicles and want to get back to being ranked number 33 out of 35.
Mr. Probyn: I agree with you. However, I would point out on the subject of international comparisons, Department of Finance officials referred to the IDS structures in the United States. That is actually an invention of Canadian investment bankers operating in the U.S.
The Chairman: That instrument was a Canadian invention?
Mr. Probyn: Absolutely.
The Chairman: By which institution?
Mr. Probyn: There are a number of them. CIBC has been active in that market, as has RBC, and I suppose some of the others, such as Scotiabank.
We brought that financial technology to U.S. markets, but the U.S. has had these kinds of flow-through structures for years. There are limited partnerships; master limited partnerships, which are listed, and REITs.
Senator Angus: Funds of funds.
Mr. Probyn: Absolutely.
The Chairman: To be fair, the tax structure there is somewhat different from the tax structure here. It is taxed more on the flow-through than it is here. That is what the paper says and that is what our analysis says.
Mr. Coutu: There is one other difference as well, and that is that the taxation on corporate dividends is much lower, so the differential you were talking about before is very slim and it does not coerce corporations to convert. I think that is the crux of the problem here. There is that delta, as you properly identified, and I think the Department of Finance is trying to stem the flow of their greatest fear, that is, a wholesale conversion of corporate Canada into trusts. That may not be the best end game because, by and large, the trusts do well with mature assets and corporations do better with R&D and growing new businesses.
I will get to my point on the dividend, because it may be appropriate. I think the Department of Finance could solve its problem in one fell swoop. They raised the idea themselves and I think they were trying to see if the public would be opposed to it. Further to Senator Angus's point, we are the highest-taxed jurisdiction in the world. A great start to correcting that would be to deal with corporate dividends and equalize the taxation between people who receive distributions or dividends.
The Chairman: You must have read our last report on productivity. We recommended essentially that, and one of the rationales for coming to that conclusion is that we felt we had to be competitive with our major partner in the United States, not only in terms of productivity but also in terms of the productivity elements and the cost of taxation. We hear and understand that argument.
Mr. Probyn: Canada's income funds are taking a leadership role in that story. That is what we are saying today.
The Chairman: For us the question is whether there is a distortion in our existing tax structure, having in mind that there is an unequal treatment. That is an important collateral question for us.
Senator Harb: From what you are saying it sounds as though they see it as a loophole and they want to step in and plug it. You see it as an opportunity that is giving money back to consumers and investors, and you want to keep it.
It seems to me that you are sounding the alarm bells. You are saying that if you move in you will create a panic in the market. You read the story of Mary, who was not happy because she lost a lot of money. Are you telling us that the approach we are using may not be the best one; that we have to approach it in systematic fashion that could address the disparity that exists between our taxation system and that of other partners?
Mr. Probyn: That is absolutely correct, senator. That is what we are saying. We think our sector has huge potential for stimulating growth, productivity and economic development in Canada. We feel that it will stand scrutiny. We are not afraid of a rational process. What we are very concerned about is that it has somehow been predetermined. That is the issue.
Senator Harb: I want to ask a blunt question. I think it is important for both the government and us to hear it, and my hope is that you will answer it. If the government moved to tax you as it taxes corporations, what impact would that have on your funds?
Mr. Probyn: It would be extremely adverse.
Mr. Coutu: Worse than that, it would be catastrophic. It would bring down the markets. I cannot even imagine that thoughtful people would entertain a wholesale taxation structure for trusts. I come here with the not-naive assumption that draconian things like that will not happen.
Senator Harb: In fairness, yours is an emerging organization growing at a fast rate. You may not have had a chance to do an impact study. Perhaps this might be an opportunity for you to do that and to share it with us, unless you have already done that.
Mr. Probyn: Our submission will address that, senator.
There are other impacts. One that I would like to briefly point out is the impact of Canadianization. If we were to go back four years, we would see a significant discussion of the hollowing out of corporate Canada and how management offices had been moving to various U.S. locations. It is not just happening in the oil industry. The trusts have repatriated billions of dollars of Canadian resources. Mr. Coutu and Mr. Kesteven live and work in Calgary, not in Denver.
If I may crave one indulgence, I would ask Mr. Hollands to talk about how the trust structure enabled the Canadian A&W chain to become a world leader, because it reasonably illustrates the way in which these productive forces play a role, not just in the energy sector but in the food service industry and in other sectors.
Paul Hollands, President and CEO, A&W Food Services of Canada Inc.; Canadian Association of Income Funds: Senators, most of you know A&W and have probably eaten Teen Burgers.
A&W Canada is a separate business from A&W everywhere else in the world. I have worked in the business for 25 years. For a large part of its life, it was owned by a large Dutch-English conglomerate. In mid-1995, there was an opportunity for management to undertake a buyout of the business to put it squarely in Canadian hands, which we did. In undertaking a buyout, you take on an enormous amount of risk and, often, a lot of debt. The emergence of the business trust market enabled us to restructure the business to access the equity capital markets in a way whereby we could literally retire all that debt and repatriate the business to our hands. It strengthened the business dramatically because we were rid of all that debt.
Historically, typical equity markets have not been particularly kind to the restaurant business. It is not a sexy business, as high tech was in 1999, 2000 or 2001, but it can grow steadily. The restaurant business is a strong cash producer and employs a lot of people. This structure is admirably suited for that kind of business. As a result, we were the first restaurant trust to market and have been followed by eight or nine others.
You talked about productivity. In our business, we do not buy a new piece of equipment and make something better; it is about growth. From the aspect of competitiveness, if you look at other major restaurant businesses, most of them have flourished and have significant reinvestment programs. Boston Pizza, as many of you will be aware, is rolling out in the Ontario market quite rapidly and is investing in new restaurants at the rate of about $60 million a year. That is $300 million in just over five years.
Senator Angus: In Canada.
Mr. Hollands: Just in Canada. I know the folks there well. They are adding about 1,600 employees a year. In our business, we are building about 25 restaurants a year. Today we have a base of 19,000 to 20,000 employees in the entire business. We add about 1,000 new employees a year as we grow. Given our structure and access to the market, our unit holders get great cash distributions and we are able to flourish and grow. We have a structure that works well.
Senator Hervieux-Payette: I have to say that I know Mr. Probyn from the time when I was consulting on an energy project with my colleague's firm, Stikeman Elliott. This vehicle for financing new energy projects was never questioned until this conversion trend arose. Existing businesses did not have to necessarily create one single job, but they took advantage of the tax benefit that really was meant for new Canadian entities, for acquisition or for investment in new business or growth, such as the Syncrude project.
In addition, I can tell you I have probably 0.0001 per cent of the PrimeWest shares, and yet at 2 per cent I could not retire from the Senate. When one acquires such an investment, it is certainly not to retire. There is another purpose; it is a long-term investment.
I supported energy projects, thinking that one day they would be great projects. I was there when the tar sands policy was established. Trusts are in place because they produce new projects, such as mini-hydro projects at the time when I met you. It was perfectly proper and for 20 years it worked well. All of a sudden, that tax vehicle is being used for other purposes — to save taxes. Of course, the trusts are being sold to the people, but they were never questioned before. You never had any trouble putting together your deals and you used that vehicle as part of the normal course of operations. Now we have communication companies and banks talking about converting to income trusts. Did you see that coming? Did you see that it would hurt your own entities?
Mr. Probyn: Senator, it is wonderful to see you again.
Senator Angus: We feel the same way.
Mr. Probyn: We had many interesting conversations about project financing. I remember SNC-Lavalin when you were there in a senior capacity.
In the power industry, project finance and the trust market are in many ways two sides of the same coin. A project financier raises debt against long-term contracts. Typically, power trusts also have long-term contracts to stabilize cash flows and ensure the long-run viability of their business. What we have seen is an evolution into a new forum.
I recently met with representatives of a major U.S. investment bank in New York. One of the senior executives complained to me that the cost of capital for the Canadian utility industry is so much lower than the U.S. cost of capital that they really found it difficult to make investments and to acquire Canadian utility assets. With respect to the efficiencies of the long-term debt that we used to talk about and implement all those years ago, I think that we have moved to a more efficient structure in the power industry.
It is a move towards capital efficiency, and it produces benefits for Canada.
Senator Hervieux-Payette: Do you not think that when we have a tax system that has produced good results, if some other group wants to use it for another purpose, which is not to produce growth or new wealth but just to take advantage of the tax system, you are the big loser? I say, do we need guidelines to make sure that this income trust can stay in place, but with some requirements? When you try to claim the tax credit related to innovation, you have to conform to a certain number of guidelines and, if you do not, you do not get the tax benefit.
In this case, if there is a tax structure that is not the same but is advantageous to Canada, why not ensure that it serves the purpose and not have people taking advantage of the tax structure, but create the productivity or the wealth that we want? You have new entities. You are acquiring new fields or new installations. There is productivity, Mr. Chair. If one day a company is an “A” type and then the next it is a “B” type and there is not one cent invested in the new company, I do not think that was the purpose of this structure.
The Chairman: I would appreciate it if you could be precise and concise in your responses. It is a long question, but it requires some precision and, hopefully, some cogency.
Mr. Coutu: I will admit that I do not know what the original reasons were for the trust rules, but I would suggest something that you ought to also understand regarding productivity, that the people who run trusts also have to embrace a different way to do business, which brings a new form of discipline to the businesses under trust structures.
Distributions may not always be compelling because interest rates may not always be that low, in which case, I would submit that the trust structures will prevail. I will tell you that investors love the discipline that this has instilled, particularly in a time when governance has become such a high-profile issue. The only way corporations can press for discipline is with governance.
With trusts, you have to send investors a cheque every month or every quarter, and that is the discipline. The investor who owns a trust actually makes the decision as to whether or not you will be able to invest that cash flow in a growing project as we have been able to do, or they will sell your stock. Management recognizes that, so they know they cannot invest there. They have to keep that cash out. It is a new approach to business, and I would suggest to you it is a much more disciplined approach and much more responsive to investors. I do not know what the original reasons for trust structures were, but today it has evolved into that.
The Chairman: The history goes back for 20-odd years. It really went back to real estate investment trusts, where money was locked in and there was a way of flowing it through so that the shareholders could share as partners, in effect, in real estate deals, and that was transferred to the oil fields. Now, as Senator Hervieux-Payette has pointed out, it is “morphing” into all corporations. That is why we are trying to come to grips with whether the original rationale still holds true or whether it has transformed the system in such a way that it becomes cost productive. We are trying to have an honest discussion with you.
Mr. Hollands: One important insight we have learned from this is that the market for income trusts exists because of a need by investors.
The Chairman: Quite so.
Mr. Hollands: As Mr. Probyn would say, if there is $300-million worth of tax leakage on $170-billion worth of market cap, that is a very small number. It cannot just be the tax that is driving that. It is the need for cash. If you look at the demography and the returns that average Canadians can get on their RRSPs, it is so small that they say they need cash. There are these businesses that can generate cash. The market is saying, “We have high value for the cash that you can produce.” If it does not impair the business, it is a good business and it keeps moving forward and can satisfy that need in the Canadian economy, it is a good thing.
The risk is that we focus on the income trust structure that is driving this versus what is going on with Canadians underneath that.
Mr. Coutu: I was impressed with the exchange you had with Finance, so I commend you for that. One issue that has not arisen here and that I think has always been there is the concept of limited foreign ownership in trusts. I would like to ensure that that is also addressed in these proceedings.
The Chairman: I think you have made that point.
Mr. Coutu: Thank you very much.
The Chairman: Thank you, Mr. Coutu. You understand that Senator Angus is not just another pretty face. There is some serious grey matter behind that beautiful complexion of his.
Ladies and gentlemen, I thank you all for this hearing. I can assure you that this committee is open minded about these issues. We have had a fruitful exchange and have taken a fresh look at this from a different perspective. We thank you for this. It has been candid.
I take the Department of Finance at their word. We have heard from Mr. Farber and his officials that there is no predetermination here, notwithstanding some comments we might have heard. That is what we heard today in testimony under oath.
Senator Angus: They are not under oath.
The Chairman: Well, not under oath, but in front of a committee of Parliament, and we take that as a given. Frankly, we will be watching this carefully. When the minister comes, we will ask him the same types of questions related to the issue of fairness. If there is a consultative process, and the government has announced that, it is our task as an oversight committee to ensure that that process is open and fair. In that way, I think we can chase out all the exaggeration in the marketplace and stabilize it. That is in our interest as a committee and I think in your interest as investors and entrepreneurs. We thank you very much for your candid exchange here, to be continued.
Mr. Probyn: We look forward to coming back.
The committee adjourned.