One of my readers (who happens to be a stockbroker in Canada) had this to say:

" Bill: I think you miss the point with the trust Fiasco, this is not about the merits of income trusts--I have heard knowledgeable debate both ways. This is about the de facto expropriation of people's assets. The government gave every indication that they would support the asset class and individuals of a less cynical nature than you, who believed the government, are now disproportionately footing the bill for this tax grab. This is no different than Chavez changing the royalty tax in Venezuela. Whatever the government's reason, your investment is now worth less. I think an investor could be excused for thinking that the government whole heartedly supported income trusts if he had read Harper's letter to the editor from a year ago."

Here is the background to this "fiasco":

Starting in 2011, business trusts, which had heretofore paid zero tax, will pay tax at the 31.5 pct federal corporate tax rate on all earnings, plus 13 pct on account of provincial tax. The latter amount will apparently be held for distribution to provinces based on a reasonable allocation to be negotiated in the future.

All distributions deemed to be "return of capital" will be untaxed. Tax-deferred accounts will continue to pay no tax on receipt of distributions.

Simultaneously, the government stated an intention to reduce personal income tax for all Canadians and to make additional concessions to the elderly.

The investors who are screaming mad today are the Canadian-based tax deferred accounts and non-resident investors who bought these financial products on the basis that all distributions to them would come from income that would be untaxed at the corporate level.

The U.S.-resident unitholders are upset as they would see their gross distribution reduced by 26.5 pct. However, there are tax withholdings on dividends that complicate the non-resident issue.

The impact of the corporate tax is shown in this table.

The rationale for the immediate price reaction is well explained in the following table presented in a Nov 2 TD Newcrest report. Download TD New Reality for Cdn Business Trusts report.

Taxable Canadian shareholders, who have been benefiting from the dividend tax credit, are unaffected. And, starting in 2011, the government has stated an intention to lower the personal income tax rate.

Here's how I see the issue, and why I am obviously going to be at odds with the affected (and upset) parties. Real money was lost here " some heavily margined accounts were wiped out. Emotions are raw.

In trying to explain my position, there is no way I can win. All I can do is explain where I am coming from.

I fundamentally believe that the equity market represents prices and I trade those prices. I'm not a tax advisor or a salesman of financial products. My interest as trader is to study the real value of equity in a company versus the company's share price.

So, bottom line, if you want to talk taxes or tax schemes, or financial products like trusts and mutual funds, I'm not interested. I have associates who do that very well. As to my blog, it's about capital markets and social equity.

As a taxpayer, at the end of the day, you either believe that tax should be deducted at source so that distributions to shareholders are equal " ie, a buck is a buck " or you believe that a tax basis of the recipient ought to drive corporate structures and capital markets.

I cannot accept the latter.

I have always been a believer that tax advisors, lawyers, law courts, and politicians should be as far away from capital markets as possible. Traders need a level playing field wherever they can get it. This tax normalization policy from Minister Flaherty is a good one, although extremely badly introduced.

Obviously tax advisors, lawyers and salespersons who sell tax-advantaged products believe otherwise, but, as I see it, why should all the traders of capital markets be subjected to the financial interests of a relatively few people?

As a capital markets trader, I believe the equity of a company is a representation of the real value of a company net of liabilities. A company is not a business trust, which is a recently contrived tax scheme for some of the owners of the company.

With a business trust arrangement, the government, which is the company's taxing authority, has, as I see it, been made an agent of polarization for bankers and lawyers, and this needs to stop. We need our political representatives to stop kow-towing to vested interests.
Taxpayers and traders alike need a level playing field.

I see the same type of thing happening in recent years where hedge funds have been created as financial products rather than dealing with the reality that they are capital managers who have control of other people's money. A hedge fund is no different than any investment fund and it and the capital managers need to be regulated the same as any other fund and capital manager.

Where did we get off the rails?

About twenty-five years ago, I noticed the changes in capital markets as bankers and lawyers became exceedingly powerful. It started when the banks started referring to their licensed salespersons as investment advisors. It's now gotten to a point where a company is a so-called trust, and the public goes along with it because, as the expression goes, "you can't fight the banks" who created these products.

At the end of the day, there is a fundamental change that is happening in markets. The market is becoming less about prices " the bids and offers " and more about financial products and services.

No longer can a corporate or economic report be issued, where stock and bond traders in the past could say with almost certainty how those prices should react, where today those traders have to wait until the vested interests and controlling parties spin their story.

That's not a market; it's a game.

So you can call a company a trust or an investment fund a hedge fund and you can set all the rules you want, but at the end of the game those with the biggest vested interests will win because it's not a free market.

What happened on October 31 in Ottawa is that the government put its foot down, and they won because they make the rules. In this case, I don't mind because I see it as a necessary move toward tax fairness for all of Canadian society. Next time, however, I might be just as mad as those tax-deferred accounts are today, which just goes to my point that governments and tax-advisors ought to play no role in capital markets.

This is a complex issue, however, and BMO discussed it in that light on Nov 1, soon after hearing the word from Ottawa. Download BMO Notes on Complex Issues re Cdn Trusts.

The Canadian income trusts that were the most severely affected in the market sell-off were the ones that had high levels of non-resident ownership, and that included some of the Canadian Oil & Gas Trusts. For those who are interested, TD reported on the market's impact on these energy trusts. Download TD's report on Taxing O&G Income Trusts.

Here is some correspondence I received from a reader who is a tax expert in Canada. Two of the letters came in this weekend and two in November 2005 after the previous (Liberal) government gave an indication that changes like this were forthcoming.

I disagree with my reader's position because his perspective is tax related whereas mine is market price related. As I say, I'm just a trader and a blogger, but one who wants you to see it all.

Nov.4, 2006,

Bill, If you can stop a moment from slapping yourself in the back on the decision this week for a Finance Minister waking up in the middle of the night and saying "Tomorrow I think I'll break all my election promises and tax everyone with the surname beginning with the letter T...".

You may rightfully gloat if/when the trust sector fails to make adequate distributions (due to deceptive accounting practices - the Al Rosen concern, return of capital rather than return on capital, excessive compensation, overvaluation from a cash flow perspective etc.) because that is based on economic developments over a full business cycle. It is not right to gloat if a sector is arbitrarily shot by a Minister in the dark of night. The credit/blame must go to him rightfully and not to yourself since the decline was due to his decision alone and not on economicompany specific developments etc. where you can rightfully take a bow for your readers

I haven't read all your Trust readings but here's a fresh view if you want your readers to see a balanced view - it's a short primer on the whole subject of trusts versus "flow thru" entities like trusts and partnerships;

There is nothing inherently better about one form over the other - for most of recorded history any time a group of individuals got together for a common enterprise it was always done in "flow thru" form meaning that all the spoils always went to the risk takers - if King Ferdinand risked ships/lives then he received all the spoils when Columbus was successful and he was free to either a) spend b) re-allocate or c) re-invest. It is only with the Industrial Age and the development of tort law and an income tax system and a system designed to "catch the income at source" ie the corporate tax system that the spoils first had to be shared with the government before distribution to the risk takers. Flow thru entities like trusts and partnerships are much older forms of organization and much less paternalistic.

It should be clear that from an economic perspective whether a group of Joes calls themselves a corporation or a flow thru entity should not affect the outcome of their efforts and intellect. If a government blesses both forms of organization then the citizens should be entitled to invest in whichever form they prefer without fear of being penalized for making a free choice.

If from a tax perspective they prefer the corporate "withhold at source" tax payment, automatic reinvestment (retained earnings) and minimal dividend (circa 2% average) over the flow thru ("pay immediately" at top marginal rates or ,if invested in a deferred tax plan , "pay much more tax later " due to tax free compounding until withdrawal) model the choice should be theirs if govt blesses both forms of organization.

If at some later point in time a govt decides radically change part of the system and in this case to bless only one form of organization over another then morally and based on precedent dating back to the introduction of the Income Tax Act the normal course would be to grandfather the citizenry entrapped in a previously blessed form of organization. If the wish is to abolish over time then the precedent is to phase in over very long periods of time ie 10 years in the case where they forced taxpayers to go to a calendar year end and 21 years for deemed realizations in trusts. In this fashion the pain of reneging on a particular group is deferred as long as possible.

Some random points;

Are ALL trusts bad enterprises ? No. Most used to be called corps. They just changed their name and their distribution policy.
Are ALL corporations bad enterprises ? No.

Are all trusts playing accounting games in showing their bottom line? No, there is a lack of consistency but there are good and bad report cards for distributable cash. It's much harder to fake cash than "earnings" and they pay out cash.
Are all corporations playing accounting games with their "earnings" statement? No but they have a much easier time in conning the public with variants like "pro forma", "adjusted" earnings, EBITDA etc. Since they pay out almost no cash there's really no test of whether they're an Enron or not. Auditors are as blind as a bat, the media can play "beat by a penny" and the brokerage community can talk about "ratios" as cheap based on theoretical "earnings".

Are all trusts compelled to not grow or not grow as fast as corporations? Legally there is no limit to their growth (they could finance a purchase of all the corporations in the country and leave the country as one big trust...). Mechanically organic growth is a tad more difficult because they have to first distribute the cash (ie actually show they have cash to distribute - which is generally better proof of "earnings' than "earnings") but they can (and do) ask for it right back in the form of financings if they wish to grow. On the other hand some trusts are just terminal annuities - some REITS and royalty trusts which are capitalizing a finite annuity stream over the life of an asset(s). Corporations are doing the same thing internally every day but the public doesn't get to participate directly because we have a paternalistic tax system.
Are all corporations growing (unlike the trust market)? No it's just like life some are dying, some are thriving, some are in maintenance mode.

Why does the public want trusts and the govt doesn't?

The public doesn't want trusts because they're trusts, but because they had higher initial payouts due to their tax model where the tax is trapped at the individual level rather than the corporate level. Bay St. had a lay-up in selling trusts to the public when GIC's went to 1%+ in Greenspan's panic post bubble years. However, the real problem is not whether one form of organization is better than the other one (it's the same group of Joes doing the same thing except under diffenent names and distribution policies - one has a paternalistic tax at source, retain and pay out peanuts and the other is pay out all the spoils then decide whether to reinvest). The real problem and the reason for the migration is that over time Bay St. and the "system" (the execs, the buy side, the media) allowed the corporate dividend payouts to become non-existent. Back in the 50's one could get 4-5% in a low interest rate environment which was growing much faster than today. ..However, with all the accounting games going on (options, pension plan underaccruals, recurring "one-time" write-offs, off balance sheet etc.) it's been too difficult to pay out real earnings and the "system" has gone along with it.

Finally, whether a govt decides to abolish one form over another or not. is a moot point. If it opts for the corporate form because it wants to catch their tax at source then a sea change is necessary in corporate dividend payout policy.

The root cause for the migration should be addressed. Non existent payout policies led to the migration, not income tax reduction or deferral (Bay St. always sold these products on yield first, after tax issues were totally secondary - Bay St in general doesn't understand taxes very well...). In any event it's a sad week for democracy - whether one agrees with abolishment or not, the tradition has always been to grandfather so two promises were broken - an election promise which is the basis of democracy and the promise of generally following precedent in tax law.

Everyone's always known that it's a waste of time and money for an economy to be converting their names. Canada should use this opportunity to address the major issues 1) payout policies for all organizations should be more reasonable - pre -tax margins have always been in the 10-12% range so a 4-5% payout policy should be the average threshold - paying out much lower leads to Enron, option scandals, and conversions... and 2) maybe readdress the issue of where the govt catches the tax - is it written by God that ALL tax must be captured at source? - can individuals be trusted to pay their fair share (probably not)?

Canada has annual tax revenues of 186 BILLION of which about 30 BILLION are corp - a tax "leakage" of 500-800 million for income trusts constitutes a grand total of .26 of 1% of annual revenues for a govt with a 13 billion surplus (after giving away 5 BILLION in GST ). Where are the public studies to support the leakage?

The govt has ;
a) a windfall on conversion capital gains
b) a windfall on taxable investors (top rate individual investors pay much more than corporations)
c) a huge windfall on the tax that will ultimately be collected from tax deferred investors because with tax free compounding at much higher payouts will mean huge increases in Ottawa's coffers - but this is down the road when the current politicians are not in office...).

Offsetting these windfall gains, are;
a) lost revenue on payouts to deferred tax entities and reduced revenue on foreigners.

Unless one has the seen these numbers/estimates in the light of day how can one possibly get up on their soapbox and pontificate one way or the other? Whatever happened to the spoils to the risk takers philosophy which prevailed until the advent of corporations and the imposition of income taxes? Are we too stupid to question our govt any more and take their every word as gospel?

Regards,

---

(Follow-up to my reply)
Thanks for the response - always enjoy your work whether I agree or not.

As for the politicos - I like the coverage on Kinky Friedman's motto while running for office in Texas "How hard can it be?" For a minority Finance Minister with virtually no financial background to break a 90 year old tradition of grandfathering - the same individual whose solution to homelessness was to declare it illegal...

In any event the non-existent payout policies are at the root of today's sturm and drang.

Regards,

---

Nov 18, 2005

Bill, Just my 2 cents on Canadian trusts (from a former tax CA,CFA - I hope it doesn't totally discredit my thoughts...). I actually think the trust form is truer to the original intent of corporations (organizing activities undertaken by groups with a specific purpose into separate legal entities so as to limit liabilities and raise capital with the attendant rights/obligations of using other peoples' money for their activities).

From a tax perspective a trust (like partnerships) is just a conduit. A conversion to a trust is just shifting the tax burden from the corporation to the individual/institutions. The tax impact is minimal ie individuals are generally taxed at a higher rate than corps, conversions to trusts usually creates capital gains which is a windfall for Ottawa and yes if the recipient is registered there is a shortfall but if one does the full spreadsheet of 8% compounding (roughly the yield these days on the Trust index) in an RSP for say 20 years versus 2% compounding (the yield on corps in the TSX) the extra tax collected on the way out should offset much if not all of the current tax forgone (probably around 3% - based on average pre-tax margins of around 10% - based on companies selling for approx 1 times sales).

Whether one calls a group a corp, trust or partnership should not matter. The question of payouts on trusts ie say 8% (this number is obviously skewed by energy/mining trust where clearly a significant portion is a return of capital rather than "true yield") versus 2% on dividends on the surface does not seem to be a problem. Post war the TSX like the S&P has probably thru cycles averaged pre-tax yields of 12% and around 8% after tax. Thus for companies to pay out 7-8% over time without paying tax is not unreasonable ie there should be a cushion building up for down cycles (I'd like to see them pay out more like 6-7%).

The question regarding sustainability in a recession is a good one - nobody knows what will happen and what the reaction will be. Are there any bad trusts out there - of course and growing daily? There are over 200 trusts and I probably think only about 1/3 would not cut payouts in a recession. The problem for me is not the trusts (yes they're mismarketed like real estate partnerships back in the 80's by Bay St.) but corps. Corps on the TSX and S&P are paying only 2% when we know they should be able to pay 5% if they're really making what they're saying they're making (not the ex-items, proforma, normalized BS) ie if they're making pre-tax 12% (that's a number Buffett used to describe the last 50 years in a Fortune article).

However, to ask corps to dish out 5% hits directly at most of the abuses of the "New Financial" credit era. When one allows corps to fall to 2% yields (whatever happened to the old rule about buy at 6% sell at 3% yields) it invites all the shenanigans. Companies/analysts/financial media would be hard pressed to both pay out the cash AND cover unexpensed options/fully funded pensions and the recurring one time write-offs. Perhaps much of the abuses of the last 10 years would have been either prevented/uncovered a lot sooner if this discipline had been maintained. I think the answer on trusts is to eliminate corp tax (it's peanuts in the budget) and make corps compete with trusts/partnerships for making reasonable payouts. In other words corps are trusts are partnerships as Gertrude Stein might have said.

As to growth and capital formation - the rigour of making regular material payouts should in no way limit any entity's ability to raise capital thru bonds/prefs/common/units - in fact it may be arguable that "proof" of one's earnings thru payouts should enhance one's access to more capital not less. Failure on the part of shareholders to demand higher payouts makes it too easy to hide overpriced shares (which everyone wants) and pushes Bay St/Wall St to unproductive activities like calling a group activity by another name...and "creating" wealth.

Regards,

---

(Follow-up to my reply)
By all means - I enjoy your public service. Be forewarned that to my mind it's not an easy subject (that's why Ottawa ignored it for so long) if you get into a fuller discussion of trusts - the US has different tax treatment and legislative requirements -the main impediment is that once a trust is established it is essentially frozen meaning it's difficult to grow - (that's why the US version Income Deposit Securities hasn't taken off).On the Canadian side if Goodale goes after trusts he has to deal with all the flavours - mutual funds which are trusts for tax purposes as well as inter-vivos trusts, testamentary trusts etc. It's kind of a mess when it comes to reporting already ie trusts are supposed to file by the end of March but if the trusts themselves hold trust securities that also don't have to file by the end of March then it's technically impossible for trusts mentioned first to file complete and accurate returns on time. Just bizarre...

Regards,

I do agree that Canada needs total tax reform. I'd like to see the government of the day make the decision to start the process.