Mr. Chairman,
Thank you for inviting me to participate in these hearings. As a former officer of the Department of Finance I have always had the highest respect for the work of this Committee.
At the outset, I would like to emphasize that I am here in a personal capacity. I am retired and I receive no remuneration for my work on this issue. Moreover, I did not personally lose any money as a result of the October 31, 2006 announcement. My sole motivation is clarity and transparency in government policies.
My comments will focus mainly on the allegation of tax leakage and the impact of the draft legislative proposals on government tax revenue.
1. THE ALLEGATION OF TAX LEAKAGE THAT IS CENTRAL TO THE NEW POLICY IS UNFOUNDED
What we are told on the issue of tax revenue can be summarized as follows:
- Trusts don't pay taxes.
- The government will lose billions in tax revenue due to trust conversions.
- The tax burden will fall on the shoulders of hard working Canadians.
- This situation is most unfair and threatens the welfare of Canadians.
This denunciation of this alleged massive tax leakage and blatant unfairness led to a swell of indignation in the media and various quarters less familiar with financial matters. Who in his right mind could oppose the proposed measures to put an end to this horrible situation? Tax fairness, whatever it means, was suddenly seen as being worth more that the few tens of billions of dollars wiped out permanently from the retirement savings of hard working Canadians.
While putting heavy emphasis on the alleged loss of tax revenue, Minister Flaherty did not however care to document his allegation and no serious or credible study in support of his policy measures has been released. After three months of refusal to do so the Minister finally came forward in extremis thanks to these hearings. The minister emphasized on Tuesday that the Department of Finance (DoF) has used the same methodology that was used in the Consultation Paper issued in 2005. This is not reassuring.
Since November 01, 2006 the allegation of tax leakage has come under scrutiny in a number of analytical papers and articles. The tax leakage argument has been found incorrect and unsubstantiated, not only by critiques of the Minister's decision but also by some of his supporters. One of the latter, Mr. Gwyn Morgan,1 dismissed the allegation that there was tax leakage and that the tax burden was being shifted to individual taxpayers, although he opined that some leakage occurred in the case of non-residents. His support for the Minister's decision was based on other considerations that will be addressed by other witnesses.
I personally wrote two papers (one in November2 and the other in January3) both of which have been tabled. My overall thesis, particularly in my January paper, is that it is the measures contained in the draft legislative proposals, and not the existence of the income trusts, that will lead to a loss of tax revenue.
Let me make three general points to address widespread misunderstandings. First, the fact that trust distributions are not taxed at the source (i.e., at the trust level) does not mean that taxes are not paid. Second, it is not the trusts, the corporations or the individuals that are taxed, it is their income. Third, RRSPs and pension funds are not tax-exempt but tax-deferred entities. What matters from the point of view of global tax revenue is that all income is taxed as it should in accordance with the Income Tax Act.
2. ATTEMPTS TO QUANTIFY THE TAX LEAKAGE ARE BADLY FLAWED
The first attempt to quantify the alleged tax leakage was made in the September 2005 DoF Consultation Paper. Unfortunately, many of the assumptions made in that paper were completely incorrect and led to the erroneous conclusion that a significant tax leakage occurs. These incorrect assumptions led to the underestimation of the amounts paid out by the trusts to their unit holders, and therefore taxes paid by the latter, and an overestimation of taxes collected from public corporations and their shareholders. These problems are outlined in more detail in pages 4 and 5 of my paper "Income Trusts and Taxation -- Is It Worth the Cost and the Turmoil?" Since then the problem has become even more pronounced due to the reduction in the corporate tax rate and the enhancing of the dividend tax credit.
Another fundamental problem found in that Consultation Paper, as well as the Backgrounder to the October 2006 statement of Minister Flaherty, is the treatment of RRSPs and pension funds as "tax exempt" entities. The reasoning is as follows: distributions are not taxed at the trust level and are not taxed when deposited in RRSPs and pension funds. Therefore the government loses tax revenue. The reality is that these retirement saving entities are not-tax exempt but tax-deferred entities. As Mr. Morgan said so well "even those holding trust units in tax-deferred accounts would sooner or later pay the piper".
Basing itself on the provisions of the Income Tax Act here is what the Department of Finance says on this subject in its Glossary of Frequently Used Terms as posted on its Internet site. "Tax Deferral. A deferral of income taxes from the current taxation year to a later year. Registered Pension Plans (RPPs), ��..,and Registered Retirement Savings Plans (RRSPs) all provide tax deferrals. Income contributed to an RRSP, for example, is not taxed (because of the RRSP deduction) in the year the contribution is made. However, it is taxed in a later year when the proceeds are withdrawn from the RRSP. Likewise investment income earned on the contribution is taxed at the time of withdrawal rather than in each year as it is earned."
Using the definition of the Department of Finance this means that if RRSP holders and pension funds increase their participation in a growing income trust market, the fundamental issue of tax leakage is the foregone current tax revenue and the deferral of those tax revenues rather than a pure and simple loss of that revenue. There would only be a tax leakage if the present value of future taxes were inferior to the value of taxes foregone at the present time.
We appreciate the fact that the Department of Finance may look at the issue from the angle of the annual budget as Minister Flaherty said, but this cash accounting method can certainly not be used to argue that taxes are not paid and that a harmful loss of tax revenue occurs. It is ridiculous to use such an accounting technicality to pretend that the cost of this alleged loss of tax revenue will fall on the shoulders of hard working citizens and that it threatens the social programs and the capacity of the government to reduce personal income tax.
Officials of the Department of Finance cannot argue that these entities are tax-exempt when it suits them to show a tax revenue loss and then argue they are tax-deferred when it suits them to collect taxes. In 2004 Canadians contributed $38 billion to these tax-deferred entities but withdrew $52.5 billion fully taxed at their highest marginal tax rate. The tax-deferred status of these entities might have presented a budgetary problem in the early years of their existence. However, due to the gigantic amounts now accumulated in them the taxable annual withdrawals exceed by far the tax-deferred new contributions made annually. The argument of tax leakage attributed to RRSPs and pension funds is clearly without foundation even on an annual budgetary basis.
Let me say a word about Professor Mintz's October 2006 paper on the revenue effects of income trust conversions. Professor Mintz made it clear in one of the footnotes to his paper that most of the data he used to base his calculations were taken from the September 2005 DoF Consultation Paper. His paper, he added, was an attempt "to update values to 2006". This raises some very serious questions about his calculations considering what we just said about the badly flawed nature of the September 2005 Consultation Paper.
The new updated numbers tabled by the minister on Tuesday suffer from the same flawed methodology and assumptions used in the 2005 Consultation Paper.
3. THE MEASURES CONTAINED IN THE DRAFT LEGISLATION PROPOSALS WILL LEAD TO A LOSS OF TAX REVENUE
We would now like to discuss the impact of the draft legislative proposals on government tax revenue. In order to do so we will discuss this impact on three groups of investors, namely: 1) those with fully taxable accounts (i.e., non tax-deferred); 2) RRSP holders and pension funds (the tax-deferred); and 3) the non-residents. In these notes I will only summarize the main points emerging from the more complete and detailed paper I wrote: "The Draft Legislative Proposals: A Recipe for Tax Revenue Loss." It has been tabled separately.
TAXABLE (NON TAX-DEFERRED) ACCOUNTS
The situation at present is that the government collects more taxes from these trust investors than it would collect if the trusts operated as public corporations. In their case, there is widespread agreement that there is no tax leakage, well on the contrary. This is explained by two facts: a) the amount of taxable income (i.e., distributions) is higher in the case of a trust investor because distributions are based on cash flow and not their net income like in the case of corporations; and b) taxes are paid at personal tax rates which are typically higher that the effective tax rate paid by corporations and the rates applicable to dividends.
If trusts reconvert to corporations, as it is clearly the objective of the government, both the tax base and the actual rates of taxation will go down. The overall result will be a significant reduction in taxes collected annually from these investors. At the extreme, if all trusts reconverted to corporations by 2011, the government could end up collecting only half of what it collects presently from non-deferred trust investors. It should be pointed out that the government will also lose tax revenue as a result of the massive capital losses caused by the Minister's decision.
TAX-DEFERRED ACCOUNTS (RRSPs AND PENSION FUNDS)
These accounts are thought by the Department of Finance to be by far the worst cause of tax leakage. The reason is that instead of treating them as tax-deferred accounts the Department treats them as tax-exempt for the sole reason that taxes are deferred to future years. Sooner or later all taxes are paid at the highest personal marginal tax rate. As we also said above there is no tax leakage even if the issue is considered on an annual budgetary basis.
As we said above the truth is that revenue loss would only occur if the present value of such future taxes were lower than taxes foregone when the trust distributions are deposited in these accounts. If monthly distributions received are reinvested and grow at compound rate over the years, government revenue will benefit from the taxation of the growing value of the account. If the present value method were applied the discount rate would have to be in excess of the yield on trust distributions that averages more or less 8% a year. This cannot be the case since the rate of inflation fluctuates around 2% and the yield on government long-term bonds is about 4%. Investment in trusts units by tax-deferred investors is beneficial for government tax revenue.
The prohibitive and unfair double taxation that would result from the implementation of the draft legislation proposals would make it impossible for these investors to hold trust units in their accounts. The tax rates could be as high as 57.5% (in the case of the average tax rate) and 63% (in the case of the top tax rate). See Table 2B in our paper "A Recipe for Tax Revenue Loss". These investors will have no choice but to shift their investment to lower yield instruments. They will no longer have the option of investing in high-yield trust units and this will lead to lower tax revenue for the government overtime as funds are withdrawn from RRSPs, RRIFs, and pension funds. As in the case of the non tax-deferred accounts the government will also lose tax revenue over time as a result of the massive capital losses caused by the minister's decision.
NON-RESIDENT INVESTORS
The sharp increase in taxation of distributions in their case will lead to virtually complete divestment from trust units. Since these investors are clearly in search of high yield on their investment they are most unlikely to re-invest their funds in other lower yield Canadian instruments. Foreign capital creates wealth in Canada. Apart from losing the economic benefit and the substantial indirect tax revenue arising from non-resident investment, the government will also lose the quasi totality of withholding taxes paid under present tax arrangements. This will mean a net loss of tax revenue.
It should be noted that the withholding tax is much lower (0-10%) in the case of interest paid by corporations. Since interest paid by corporations is tax deductible the government is receiving nothing or at most 10% on these interest payments depending on maturities. Moreover, the press reported on November 22, 2006 that minister Flaherty was considering cutting non-resident withholding tax on interest payments to non-residents even more in order to ease access to capital and assuage the energy sector after his decision to tax trust distributions at the source.4 The 15% withholding tax paid by non-resident trust investors is however seen by the minister as a problem of tax leakage that needs to be stopped. The logic of this escapes me.
A WORD ABOUT THE PROVINCES
The significant reduction in the overall tax base, and the concomitant global loss of tax revenue arising from the implementation of the draft legislative proposals will affect both federal and provincial governments' revenue. For many provinces the losses will be compounded by the change in the way the tax on distributions will be collected. It is proposed that the tax on distributions be collected by the province where the trust resides, and not by the province where the investor resides as is now the case. This means that provinces where there is an active investment community but where few, or no trusts are located will lose most of the taxes they now collect from their trust investors. Provinces such as Quebec, British Columbia, and Manitoba, to name but three, will be net losers.
The draft legislative proposals are heavily predicated on an alleged tax revenue loss. As we have shown this allegation is without foundation. This false allegation has however decimated the retirement savings of millions of Canadians at the tune of tens of billions of dollars. Even worse, the ability of Canadians to save for their retirement has been dealt a very severe blow since they will no longer be able to invest in the only high yield instrument available on the market. This is a problem they will have to live with for the rest of their lives.
The compensatory impact of the increase in the tax credit for age is ridiculous. A person who lost $15,000. would need about 100 years of additional age credit to recover, assuming that he or she qualifies for the full credit. Pension income splitting is welcome but is highly discriminatory as it will do nothing for millions of people without a pension to split, as well as singles, widows, widowers, and divorced who lost a chunk of their savings and will suffer from lower income for years to come. In any case, this measure has nothing to do with the trust issue and any linkage is purely artificial. What is needed is a set of measures aimed at truly compensating the hard working Canadians who lost a part of their retirement savings as a result of the minister's October 31, 2006 announcement.
5. OVERALL CONCLUSION
Our overall conclusion is that the alleged tax revenue loss attributed to present taxation policies is totally unfounded. What is worse is that, if adopted, the draft legislative proposals will lead to a significant loss of tax revenue in addition to the devastating damage done to retirement savings. So why is the government so determined to terminate the trusts? Who will benefit from this policy decision?
The draft legislative proposals should be put on hold until:
A) an in-depth and credible public study of their implications for tax revenue is conducted;
B) a set of proposals is developed to truly compensate hard working Canadians for the damage done to their retirement savings as a result of the October 31, 2006 announcement; and
C) criteria and regulations are drafted to determine which types of enterprise should be allowed and those which should not.
It is the absence of such criteria and regulations that led to the very damageable overkill we are witnessing. The minister did not have to destroy the whole trust sector in order to control the undesirable proliferation of conversions.
References:
1 Mr. Morgan is the retired founding CEO of EnCana Corp. Globe and Mail, November 2, 2006, "In the Long Term Ottawa is Right to Move on Income Trusts"
2 Income Trust Taxation: Is It Worth the Cost and the Turmoil?
3 The Draft Legislative Proposals: A Recipe for Tax Revenue Loss.
4 Globe and Mail. November 22, 2006. "Flaherty Considers Tax Cut for Foreigners" by Heather Scoffield and Steven Chase.
Yves L. Fortin
February 1st, 2007