Income trusts capped in a housekeeping budget

On the spending side, the budget, subtitled “New Agenda for Achievement,” bolsters incentives for education. On the tax-raising side, however, the budget is more concerned with forestalling tax leakage. At the same time, a number of changes are being introduced to put different kinds of taxpayers on the same footing, such as charitable foundations and charitable organizations, or disabled taxpayers who receive support grants and those who don’t.

“I didn’t expect anything significant from this budget,” says Dave Clarke, tax manager at Collins Barrow in Ottawa, adding that any major initiative was already known. Instead, there were “a lot of things that wouldn’t normally be in the budget; it seems more compliance driven.” As an example, he points to new rules for charities. Still, there were little surprises.

“The best news in this budget is not really a provision in the budget,” Tim Cestnick, managing director of AIC’s tax and estate group, says, “but that they’re going to re-evaluate the proposed change to interest deductibility.”

Proposals released in the fall looking to disqualify interest deductibility for loans made to earn capital ignited a storm. “They caused an uproar,” says Cestnick, “because the unintended result of the wording was that interest would not be fully deductible when you borrowed to invest.”

The Finance Department now says “the proposal focused not on the deductibility of a particular expense, but rather on the ability of a taxpayer to claim a loss from a business or a property.” But it acknowledged that “some commentators have nonetheless expressed concern that the proposals could have more far-reaching effects.” As a result, the Finance Department is extending the deadline for making a submission to the end of August.

“I think in the end that means they will relax the rules,” says Cestnick.

The trouble with trusts

When corporations convert to income trusts, they escape corporate income taxes by paying their earnings out to investors. While estimates of how much the federal treasury loses in corporate taxes range from $217 million to $600 million, most studies concede that the government eventually recoups the taxes from individual investors as they cash in their investments, receive distributions or withdraw from their RRSPs.

According to the budget, the income trust structure “typically shifts the taxation of income to unitholders; tax revenue foregone at the corporate level may be largely compensated by increased tax revenue at the unitholder level.” But the budget contains a caveat: “At the present time, most unitholders in income trusts are taxable.” One reason is that potential legal liabilities have kept large institutional investors away.

Should pension funds move into the trust sector, particularly the emerging business trust sector, the budget warns that it “could have a significant impact on the market and government revenues because of their tax-exempt status and their influence in Canadian capital markets.”

Not all trusts worry the government. Pension funds have been long-time investors in real estate and resource companies. Royalty trusts and real estate investment trusts will continue to be eligible investment vehicles for pension funds. But the government plans to limit pension fund participation in business trusts.

The budget proposes two measures. The first defines business trusts as restricted investment property and limits tax-exempt entities, including pension investment corporations, registered pension plan (RPP) trusts and RPP corporations to holding a maximum of 1% of the book value of their assets in restricted investment property, including direct investments in business trusts and indirect investments through mutual funds. The second measure limits pension fund participation in any business income trust to a 5% stake. In both instances, going over the limits will attract a 1% per month penalty.

The government is offering transitional relief for existing pension fund investments in business income trusts.

“I think the way they dealt with income trusts is probably ideal,” Cestnick says. “It’s not likely to affect the market for them at all. I don’t think it’s going to cause valuations to drop drastically, like it could have.”

Non-resident investors

Non-resident investors pose another tax leakage problem when it comes to investing in real estate and resource properties. If they invest in mutual funds, or products, such as income trusts that are structured like mutual funds, they generally escape taxes, while direct investors are taxed on the disposition of taxable Canadian property (TCP).

“TCP is that stuff that everyone’s taxed on, no matter where you live in the world,” says Cestnick.

To limit tax leakage, the budget proposes to treat fund distributions on the sale of TCP as Canadian-source income, for a mutual fund trust, or as taxable dividends, for a mutual fund corporation. Those distributions will be subject to a withholding tax of 15% on average. Capital gains that occur from TCP sales will also be subject to a 15% tax, although non-residents won’t have to file an income tax return. At the same time, non-residents will now also be able to claim capital losses on Canadian property, but they will have to file a special income tax form.

The rule on non-resident investors was one part of what Suzanne Schultz, an associate vice-president in AIC’s tax and estate planning group, characterizes as a budget intent on closing loopholes. All the same, she added, these are “little things that probably won’t affect a lot of people.”

For example, fines and penalties — such as parking tickets — are no longer deductible. The rules governing who is affiliated with a discretionary trust have been clarified as well as other housekeeping measures.

Charitable relief

In another instance of housecleaning, the budget contains two sets of measures targeting charities. The first set proposes a schedule of fines and penalties for charities that breach the Income Tax Act. In the past, the only sanction was the rarely used sanction of last resort: revocation of a charity’s tax-exempt status. The new measures, the budget says, are designed to bolster public confidence in how charities are run.

A more sweeping set of measures equalizes treatment of charitable foundations and charitable organizations. It reduces their annual mandated disbursements to 3.5% of the fair market value of their assets, from the current 4.5%. That figure the government considers more representative of long-term rates of return, a figure it also promises to review.

In addition charities will no longer have to spend 80% of donations they receive as designated beneficiaries of an estate. Instead, they can be applied to an endowment fund. Similarly, charities will be able to lock in capital gains without having to disburse 80% of the amount raised. Instead, they will be required to spend 80% of the gain, or 3.5% of the value of all the property it holds that is not used for administration.

Clarke says the tightening-up on compliance is not unexpected, since many charities are run by volunteers who haven’t always been aware of compliance requirements.

Caregivers and disabled taxpayers

In another move aimed at equalizing the treatment of taxpayers, the budget proposes a disability-supports deduction. It is aimed at taxpayers who receive grants for such things as sign-language interpretation or tutoring services. The grant is normally added to income, causing the taxpayer both to pay taxes and forfeit some means-tested benefits. The disability-supports deduction replaces the attendant-care expense deduction.

The budget will also allow caregivers to claim more of the expenses they incur on behalf of dependent relatives by eliminating the so-called “notch provision” that kicks in when the dependent’s income is more than the basic personal amount ($8,012) all taxpayers claim as a deduction. After that threshold, a considerable part of the Medical Expense Tax Credit (METC) is clawed away. For children, expenses can be claimed without regard to the income of the child. The dependant’s parents will be able to claim expenses of up to $5,000. That’s an improvement, but Clarke would have preferred a higher limit.

For someone earning a modest CPP disability pension, the extra income effectively wiped out the METC, Schultz notes.

2004 Federal Budget

Income trusts capped in a housekeeping budget Staying the course: No surprises in Goodale’s first budget Advisors react to “non-event” budget Budget draws mixed reviews from industry associations Industry insiders analyze return to prudence The federal budget and your financial plan (Client letter) Back to main page

Further work needed

In last year’s budget, the federal government briefly broached the idea of TPSPs. Unlike registered plans, contributions would receive no upfront tax deduction. Earnings within the plan, however, could be withdrawn tax-free. The Finance Department said that consultations after the 2003 budget “raised a number of important issues which require further consideration.”

Cestnick thinks TPSPs will eventually come. In the past, Prime Minister Paul Martin has expressed interest in them. “I just don’t think they have the money right now.”

Still, there were small measures of immediate benefit to some clients. Clarke points to the acceleration of the small-business deduction limit. The $300,000 limit has been moved ahead one year, to 2005.

All the same, given the government’s emphasis on prudence, future budgets are likely to look much like 2004’s, says Cestnick.

“They’ve pretty much said that there will be no more tax cuts in the next two years because they’re expecting revenue as a percentage of GDP to fall even further,” he explains. “It’s going to continue to fall, and that’s because of the tax breaks they’ve given over the past five years.

“This kind of housekeeping is all we’re going to see this year, next year and the year after that.”

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Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

(03/23/04)

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