Trick or treat: income trusts and charities
Adam Aptowitzer, December 28, 2006
This past Halloween, the federal government perpetrated the biggest trick in Canada when it broke an election promise and changed the taxation of income trusts in Ottawa. The change in the legislation governing trusts was precipitated by the conversion (or anticipated conversion) of several large corporations to income trusts – a move aimed at allowing the corporations in question to escape taxation at the corporate level. Given the popularity of income trusts, especially among non-taxable entities such as pension plans and non-resident investors, the government felt compelled to impose a tax on income trusts to protect the tax base.
Unfortunately, in trying to “sour the milk” for this group of non-taxable entities, the government has proposed legislation which significantly affects another part of this group: charities, not-for-profits (NFPs), and registered Canadian amateur athletic associations (RCAAAs). Arguably, more Canadians are adversely affected by the recent announcement indirectly through their dependence on these groups than those who actually held investments in income trusts.
Registered charities and other qualified donees under the Act are now missing out on what would otherwise have been a good opportunity.
While most charities understand that their investments are now worth significantly less than they were before the announcement, it will remain for advisors (including the many lawyers who serve on boards pro bono) to explain the implications of the announcement to the charity.
The government’s announcement caused a significant drop in the value of income trust units on the market. The impact of this drop on individual investors was well-covered by the media, but the impact on charities was at least as large, and likely more profound. In the near future, charities will be forced to revisit their investment strategy to determine the usefulness of holding income trust units.
Under the old system, investments in the income trust sector were favoured because the cash distributions helped charities meet their disbursement quota obligations (DQ). The DQ requires most charities to expend 3.5 per cent of their capital in a year. As a result, a system whereby the charity receives periodic tax-free cash distributions has obvious benefits. While the new system does not entirely eliminate the advantage of receiving cash distributions, it does slightly reduce the benefit of investing in income trusts, because the amount is now taxed in the hands of the trust.
The obvious intention of the government’s announcement was to end the trend of corporations changing to income trusts. However, the changes also created an unintended consequence for charities, as they were looking forward to the opportunity to convert to income trusts, which in and of themselves affected the way charities were planning on raising funds in the short term.
Even though many shareholders weren’t aware of this fact, the conversion of a corporation to a trust generally created a disposition of the shareholder’s share in the corporation, which, in turn, usually precipitated a capital gain (and therefore capital gains tax) for the shareholder. Some charities were hoping to capitalize on both this fact and recent changes to the Income Tax Act, which allowed for the donation of publicly traded securities to public foundations and charitable organizations by convincing shareholders to donate some of their shares before the conversion.
For example, a disposition of shares of BCE Inc. (the corporation which catalyzed the change by announcing a planned conversion to an income trust) would have caused large tax bills for individuals who had held their shares over a long time frame. Part of the strategy to manage the tax liability for such people would have been to donate part of their shares to a charity for a donation tax credit in order to offset the large capital gains tax. Obviously, registered charities and other qualified donees under the Act are now missing out on what would otherwise have been a good opportunity.
Under the old rules, flow-through entities, such as income trusts, would deduct the amount they paid out to unitholders from their income in the year. The trust would then deduct its distributions of income and taxable capital gains to unitholders from its income in a year, and the tax would be paid by the unitholder directly. Thus, distributions received by non-taxable entities were not taxed either at the trust level or in its hands. Income not distributed by the trust would be taxed in the trust’s hands at the highest combined federal and provincial marginal rate.
Under the new rules, distributions from the trust will be taxed at a rate equivalent to the federal general corporate tax rate, plus 13 per cent due to provincial tax (which will not be applied again at the unitholder level). The receipt of these distributions will be a deemed dividend in the hands of unitholders for the purposes of the enhanced dividend tax credit unveiled by the Liberal government shortly before the last federal election campaign. The chart below, provided by the Department of Finance in its backgrounder released with the minister’s announcement, illustrates quite simply that charities holding income trust units (or other flow-through entities) will go from paying zero per cent tax on income earned by the trust to 31.5 per cent by 2011.
Non-portfolio properties will include certain investments in a “subject entity,” Canadian resource properties, timber resource properties, and real properties situated in Canada. Without going into great detail, any other property owned by the trust or partnership will be a non-portfolio property if the partnership or trust (or a person or partnership with which it does not deal at arm’s-length) uses the property in carrying on a business in Canada. Effectively, the income trusts, other than real estate investment trusts (REITs) will be caught by the new rules.
Overall, the new legislation is going to create some very interesting questions for charities and their advisors, and the answers to these questions will not be the same for all charities. Those non-taxable entities that don’t have to consider disbursement quota obligations will likely become indifferent to holding investments in flow-through entities and large corporations. However, in the short term, charities will have to give serious consideration to the effects of the income trust announcement on their investment strategy.