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Fredericton Daily Gleaner ~ Capital Appreciation ~ Income Trusts ~ October 23, 2006 - 29 Oct 2006 by TaxHelp
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There has been lots of interest in the national business media lately about the popularity of income trusts. Of course, here in the province we are old hands having experienced the Aliant corporate conversion this past summer into the Bell Aliant Regional Communications Income Fund.
Back at the turn of the millennium which is not as long ago as it sounds, income trusts represented about $20 billion as an investment segment. Today that number is closer to $200 billion. And another couple of large telecoms are planning their conversions – Bell’s parent BCE at the end of the year and Telus early next year. So what is the attraction toward the downstream change?
Why do you buy RRSPs? Sure it’s because you’re going to retire someday – but c’mon, admit it – it’s really about lowering your tax bill today, isn’t it? The people in charge of steering these large corporations form income trusts so that they can avoid taxes. This generates a resultant jump in the stock price, thereby making their shareholders happy (and perhaps guaranteeing themselves an even larger bonus).
While the Globe and Mail had a large part of its ‘Report on Business’ section devoted to income trusts a couple of weekends back and Neil Reynolds reprint in last Thursday’s Telegraph-Journal argued about the actual tax revenue impact to the government these creations have, the consensus is that the market will continue to grow. Various sources have the market expanding to $250 billion over the next year.
If the big finance guys are going to keep doing these deals, you may want to know the skinny on how they work so you can be armed around the water cooler.
In general, income from a trust is taxed in the hands of the beneficiary or in this case the unitholder (which is the trust equivalent of the shareholder). Conversely, corporations are taxed on their profits. People with trust income pay tax on those funds at their marginal tax rate. People with shares in corporations pay tax on the income they receive (known as dividends) at their marginal rate as well. The challenge is to find a way to not have the effect of double taxation - a corporate tax and a personal tax, thereby making the underlying company more attractive to investors. Hence the popularity of income trusts. The active company creates a line item expense – royalty payments for instance – and this expense represents the profit. This royalty payment is paid to the income trust, and is a write-off (just like you write-off your RRSP contribution) thereby reducing the taxable profit at the bottom line to a negligible amount and avoiding the tax bill. It’s been suggested that the BCE change is going to allow the company to avoid $250 million in taxes next year alone.
At any rate, the trust pays the income out to the unitholder, where it is taxed in his or her hands. In light of the income trusts, Ottawa changed the way the dividend tax credit mechanism works when an individual files a tax return to make the corporation an equally attractive investment. It increased the gross-up value on dividends to 45 per cent and increased the credit to about 19 per cent. When you consider that someone who has the lowest marginal rate of 15.25 per cent this year, anyone with dividends and taxable income of less than about $35,000 will pay virtually no tax federally on that dividend income from their shares in a corporation.
Anyone who holds shares in a company that becomes an income trust may have to deal with a capital gains issue. When the shares are swapped for income trust units, even though the investor does not receive any funds the exchange is treated as a disposition. This can result in capital gains. The taxable income is calculated based on the swapped price less the cost of the share divided by two. Put another way, if someone had bought ABC Co for $10 and it is $20 on the day of the change, the profit (in this case known as a capital gain, and ignoring any sales commissions) is $10 and the taxpayer must report $5 on his tax return.
By the way, these changes are good news for qualified charities. The investor can give away his shares before the event and can avoid paying the capital gains tax. The charity issues a tax receipt for the full value of the shares. Charitable donations are step-rated in the amount of relief they create. The donation generates a non-refundable tax credit of 15.25 per cent federally and 9.68 per cent provincially, or about 25 per cent combined on the first $200. But the great news is that once you’ve moved beyond the $200 threshold the numbers increase to 29 per cent federally and 17.68 per cent provincially for a combined tax savings of almost 47 per cent. Put another way, someone who qualifies to give $10,000 in shares to charity ends up saving $4,668 in taxes. This really is enhanced if the $10,000 in shares only cost you $5,000. Just something to keep in mind if one of your holdings is eyeballing a switch!
Roger Haineault is with Help 4 Taxes. For questions, comments or column suggestions he can be reached by email at roger@help4taxes.ca or by calling 1 (888) 450-1212. His column appears Mondays. |
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