Friday, November 03, 2006

The Gordian Knot of Income Trusts

When the Liberals were floating trial balloons all over the place regarding how to deal with income trusts, Harper, then in opposition, criticized the Martin government for going after seniors and retired people.

During the election campaign of winter 2005/06 Harper made an absolute promise, in writing, in the CPoC campaign book. (Page 32)

A Conservative government will:
• Confirm its commitment to the Canada Pension Plan (CPP) and Old Age Security (OAS) as well as the Guaranteed Income Supplement (GIS) as fundamental guarantees of income security in retirement years.
Stop the Liberal attack on retirement savings and preserve income trusts by not imposing any new taxes on them.
• Protect the integrity of the CPP investment fund to stop politicians from raiding it to balance the budget or pay for other political projects.
• Protect seniors from over-taxation by raising the pension income tax amount that is eligible for a federal tax credit from $1,000 to $2,000 per year in 2006, and to $2,500 in five years.
• Appoint a Seniors Council comprised of seniors and representatives of seniors’ organizations to advise the minister responsible for seniors on issues of national importance.
(Emphasis mine)
Harper is claiming a change of circumstances. He can claim anything he wants. The man is supposedly an economist. To make that promise when the tax environment was attracting companies to convert to income trusts demonstrates a clear lack of foresight.

No matter how you cut it, Harper and his CPoC outright lied.

That aside, the complexities of income trusts are certainly beyond many of us, me especially. I asked a tax accountant what he thought of the events of the past 48 hours. The following is a summary of our conversation and is opinion in some areas mixed with a chartered accountant's reckoning of certain tax scenarios:

Income trusts were a step in the direction towards eliminating patently unfair double taxation. Corporations, before they pay dividends, must pay tax on that money. Once the money is in the hands of the investor, if it exceeds the dividend tax credit, the investor is also taxed. In short, all money exceeding the new enhanced tax credit of about $66,000 is taxed twice: once in the hands of the corporation and again when it reaches the investor.

Income trusts pay out earnings on investment without being taxed inside the trust. The investor pays taxes when the money paid to her/him is reported as income.

The Conservatives were very aware that the largest single block of investors in income trusts were retirees and pension plans. But, the attempt to ameliorate the situation by providing a greater tax credit to seniors carries another flaw. The enhanced Dividend Tax Credit has a formula called "grossing up". The taxpayer actually records, on a tax return, income from a dividend at 145% of the amount actually received. Despite the fact that, with no other earned income, $66,000 is calculated to be tax free, the retiree is now recording a higher income from dividends than in previous years. The claw-back of Old Age Pension will now affect more people than it has in the past. Thus, retirees claiming a Dividend Tax Credit stand to see some of their federal pensions and benefits from provincial seniors programs shrink.

If that sounds a little confusing consider that a retiree receives $10,000 in dividends. The amount of income actually recorded on the income tax return is $14,500. That is an increase from the previous "gross ups" and it artificially increases the reported income of the retiree. As a general rule of thumb, the higher the reported income; the more social programs are clawed back. A retiree may see a minimal tax benefit and lose some or all of previous financial benefits without a real increase in income.

The pension income splitting announced by Flaherty looks good, but it raised an immediate question from my tax accountant friend: "Why just pensions? Why not wage income?"

Why not indeed. The CPoC is supposedly a "family values" party. Yet, they introduced income splitting at the retirement level after a "stay at home" spouse had no opportunity to develop pension income. If wage income splitting was introduced it would reduce the tax-bite on Canadian households and open investment and pension doors to the "stay at home" spouse.

The suddeness of the decision and the blind-siding of both business and those who rely on income trusts for retirement income is going to create considerable damage.

The stock market melt-down was bad enough since it affected virtually every Canadian invested in a pension. Index driven mutual funds, although they may not have large numbers of income trusts in their portfolios, will still see a marked reduction in value if only because they tend to follow the market as a whole.

Worse, however, is how investors view Canada as an investment market. This move has shades of Mongolia's mining windfall tax which was rushed through in less than a week and with almost no consultation or research. There, investors are taking a second look at the worthiness of an investment in that country at all.

Canada, with this decision by Harper/Flaherty, has signalled that it is not as good an investment area as might have been previously perceived. And, that is the message coming from a conservative government.

Harper and Flaherty also sent another message that is very similar to Mongolia's. Canada does not have a stable investment climate. The suddenness of Flaherty's announcement indicates that regardless of what this government says it will do, actions are completely different. Investors can have no confidence in economic and investment stability. Where an investment vehicle is considered secure, it can be crushed with no notice and no consultation. Traditionally, if there is a concern over certain investment instruments or vehicles, budget time is the appropriate period at which to announce a review. But, from the Conservatives, there was nothing. No notice, no heads-up, no indication that they would be looking at a major investment tool for possible changes and revisions.

Investors hate instability. And, if they can get a better return on their money in an investment stable Ireland; they'll invest in Ireland.

Many corporations did not like the income trust model. To many CEOs it did not have the corporate financial discipline and the ability to retain earnings. With the cash flow going out to unit holders it made many CEOs uncomfortable. However, there was pressure to produce income for shareholders and few could argue that, in a market requiring continuous investment, the income trust was the vehicle which could attract and hold investors.

In any event, this whole move was to protect $800 million in tax revenue. To accomplish that Harper/Flaherty pulled $24 billion out of the Canadian economy, not to mention the people whose retirement incomes have now just taken a crushing blow.

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