The federal Conservatives’ decision to eliminate income trusts has generated a certain amount of fuss (even The Economist noticed), especially in the form of sharply reduced share prices for companies that had structured themselves to take advantage of the tax breaks they provided.
Much of the media coverage about the pros and cons of income trusts has revolved around the lost corporate tax revenues – the figure most often cited is Jack Mintz’ estimate of $1.1b.
But that’s not the reason why the Department of Finance clamped down; they’re running surpluses so large that an extra $1b a year would be somewhat of an embarrassment.
Although the Aggarwal and Mintz study does offer estimates for tax leakages, they aren’t the reasons given for questioning the usefulness of income trusts. The more fundamental argument is that they distort capital markets:
[S]ome firms are more likely to benefit from the income trust structure since they are able to make large distributions to investors with high degrees of leverage financing. Firms needing cash flows to invest in capital would not wish to use the income trust structure since leverage would increase their risk and, further, a penalty tax would be applied to undistributed taxable income…
To the extent that income trusts are more easily used by certain types of companies, capital will be allocated to those more able to take advantage of this form of financing. This could impair the efficiency of capital markets by directing capital to certain types of investments more suitable for income trust arrangements…
Although the income trust segment is still quite young when compared to the traditional equity markets, the early indications are that the fastest growing and highest yielding sectors have not accessed this capital market while the slowest growing and lowest yielding sectors have. From an economic efficiency viewpoint, this is a significant inter-firm distortion to be aware of, especially since part of its causation lies in the unintegrated part of the corporate tax.
If income trusts were shifting capital away from sectors that were generating the highest return, then there’s little reason to keep them.
Worthwhile Canadian Initiative 
I couldn’t agree with you more. It is a good decision on “Income Trust”, whatever your politics maybe. I think, since the question of economic efficiency, normally goes over like a lead balloon, with the general public including the always entertaining “so-called” investment community, Finance had no choice but to play up the potential income tax implications. I’m certainly not a fan of the present Conservative government but on this I think they have done well.
Now, of course, once they announced it I started to wonder why? It could just be Steven trying to make amends for the dumb GST initiative, do you think? I suspect that over at Finance they are putting together for the next budget (or the fiscal update) a broader package of tax measures to encourage investment that may have clashed with the continued growth in the income trusts as a financing tool. We’ll see soon enough.
Wait a sec … if income trusts are in industries not “generating the highest returns,” isn’t that a good thing? Income trusts distribute their earnings and depreciation, which takes capital out of those sectors and provides investors (like me) cash to inject into others. Suppose Joe’s Consolidated Buggy Whips remains a corporation. What will it productively do with retained earnings? By distributing them, and distributing depreciation cash (since it’s not going to be replacing all of its buggy whip machinery anyway), it speeds up the process of transferring capital out of the dying business. Doesn’t it?
Also, most new income trusts were spin-offs or acquisitions, not new injections of capital into new, low-return businesses. The creation of income trusts is capital moved around more than it is being created.
Am I wrong? Am I missing something?
The point is that few new or explanding firms, it makes sense to keep some retained earning to finance their expansions. (They could borrow, but that could lead to dangerous levels of leverage.) For those kinds of firms, income trusts are a bad model.
The problem was that income trusts introduced a tax distortion that penalised expanding firms, and benefited mature firms. That’s not a smart thing to do if you want capital to finance a growing economy.
I would argue that the tax distortion does not hurt expanding firms. Those firms can eliminate double taxation as by converting to income trusts, distributing the income, and financing expansion by issuing new capital (assuming, as you do, that they don’t want to borrow and become overleveraged). One of the income trusts I own actually does this — they have issued new units at least twice in the past few years, and have had no trouble with the IPOs.
You could argue that issuing new shares is not always possible. I reply that in those cases, if the prospects of the business aren’t good enough to convince investors to inject the capital, it’s better off going out as distributions. It counteracts the agency problem, where you’re never sure if the CEO really can use the captial better than you can, or whether he just wants to grow his empire. The income trust structure forces him to convince investors regularly that the company is on track.
Also, there is a distortion in that small, privately owned firms can eliminate double taxation by paying out their entire profit as salaries to the owners, who then inject the remaining capital back into the business. I bought an income trust like this in an IPO a couple of years ago. Without the availability of the income trust option, the owners may not have gone public — doing so would have immediately raised the effective tax rate on their earnings.
It seems to me this is a more common, and worse distortion — Wal-Mart needs to earn a higher rate of return to justify capital investment than Joe and Ethel’s Mart. Double taxation takes capital away from large corporations who got large by proving they could be productive, leaving it in the hands of less efficient businesses who save tax just because they’re small.
If expanding firms had the same access to capital as the mature firms who had converted themselves into income trusts, then I wouldn’t have a problem with them. But that doesn’t appear to have been the case.