Income Trust Tax Loophole Closed

UNCLAS SECTION 01 OF 03 OTTAWA 003333 SIPDIS WHA/CAN, EB/IFD/OMA, EB/IFD/OIA, EB/ESC/IEC State please pass to USTR (Mary Sullivan) USDOC FOR 4320/ITA/MAC/WH/ONIA (Walter Bastian, Geri Word) Treasury for International Affairs (Jasper Hoek) SENSITIVE SIPDIS E.0. 12958: N/A TAGS: EFIN EINV ETRD ECON CA SUBJECT: Income Trust Tax Loophole Closed Sensitive But Unclassified - protect accordingly. ¶1. (SBU) Summary: In a surprise move that sent Canada's financial markets reeling, the Canadian federal government announced on October 31 that it would start taxing income trusts as regular corporations. The GOC took the action to stem lost revenue as more Canadian companies threatened to restructure themselves as low tax entity trusts. Ottawa will start taxing newly formed Trusts as regular corporations as early as this year and existing trusts in the 2011 tax year. Canadian financial markets responded November 1 with the Toronto Stock Exchange (TSX) losing nearly C$24.5 billion in value from the trust sector; American investors hold about 20 percent (by value) of the Canadian income trusts. Reaction from the opposition parties was split with the federal Liberals attacking the Tory decision, and the Bloc Quebecois and NDP supporting it. The Liberal finance ministers of Ontario and Quebec provinces also supported the move. A growing consensus among political observers is that the Tories may in fact gain political strength in the coming months by having demonstrated tough leadership on this issue. End Summary. ¶2. (U) Canada's Minister of Finance Jim Flaherty announced the measures on October 31 to "restore balance and fairness to the federal tax system by creating a level playing field between income trusts and corporations". "Income trusts" - also known as publicly-traded flow-through entities (FTEs) - avoid most corporate taxes by distributing income to investors in monthly dividends and were intended to provide a tax break for non-commercial and portfolio investment trusts. However, FTEs had been increasingly used by widely held and publicly-traded businesses to significantly reduce their tax burden. Flaherty characterized the loss to federal and provincial tax coffers as "not appropriate." (the Province of Alberta estimated its net revenue loss due to income trusts to be about $400 million per year). ¶3. (U) FTEs in Canada have grown dramatically in recent years and now represent over C$200 billion in market capitalization. In 2006 alone, corporations representing almost C$70 billion in market capitalization have either converted themselves into FTEs or announced plans to do so, including telecommunication giants BCE Inc. (based in Montreal) and Telus Corp (based in Vancouver). In recent weeks, both companies had announced plans to become income trusts, which would have driven up the market value of trusts on the TSX by C$50 billion, resulting in an annual loss of C$800 million in SIPDIS tax revenue for the federal government. ¶4. (U) The GoC intends to introduce a new tax regime for FTEs later this year under which their tax treatment will be more like that for corporations, and their investors will be treated more like shareholders. In its news release on the tax changes, the Department of Finance claimed that Australia and the United States have "foreclosed the kind of inappropriate avoidance of entity-level tax that Canada's FTEs now exploit". TSX Takes a Nose Dive SIPDIS -------------- ¶5. (U) In reaction to the federal government's announcement, the Loonie fell eight-tenths of a cent against the U.S. dollar and the TSX experienced significant losses in trading on Wednesday, November SIPDIS ¶1. The TSX lost nearly C$24.5 billion in value from the trust Q1. The TSX lost nearly C$24.5 billion in value from the trust sector (and would-be trusts),and the S&P/TSX composite index fell 294 points (2.4 percent),the biggest single day loss in two and a half years. The S&P/TSX Capped Income Trust Index fell more than 12 percent, the most since at least 1998. No trusts on the 73-member index rose on November 2. The S&P/TSX composite index, however, closed up 80.34 points (0.7 percent) to 12,130.73 on November 2. Winners and Losers -------------- ¶6. (SBU) Among the losers, CI Financial Income Fund dropped 20 percent; Yellow Pages Income Fund fell 19 percent, and would-be trusts BCE and Telus lost 11 percent and 14 percent, respectively. BCE, Canada's largest communications company, experienced its biggest drop since 1983, when the company was formed. Though Bay Street was taken by surprise by the announcement, and industry insiders say that they were not consulted during the policy-making process, the consensus is that something needed to be done, especially in light of BCE's recent announcement that it would be converting itself into an income trust (see also para 12). OTTAWA 00003333 002 OF 003 ¶7. (U) Observers in Calgary, the hotbed of the oil and gas sector, suggest the new tax regime may lead to consolidation in the industry or greater foreign ownership of Canadaian natural resource entities, either through direct take-overs of trusts weakened by the new tax, or through their inability to acquire assets on their own. CEO Bill Andrew of Calgary-based Penn West Energy said that he expects fewer corporate offices in Calgary, with less Canadian ownership in the oil patch in general; another Calgary firm compared the announcement to putting up a "for sale" sign on Canadian energy resources. The Former CEO of Canadian energy giant EnCana, however, in a November 2 op-ed piece for the Globe and Mail said the decision required "tons of courage" by the Government and that "in the long term, Ottawa is right to move on income trusts". ¶8. (U) On Thursday, November 2, as the bleeding continued in the income trust sector, investors moved back into dividend-paying financial shares, led by Manulife Financial, up C$2.10 to C$38.40, after its better-than-expected results released the same day. Following closely behind Manulife were the Canadian banks, four of which marked 52-week highs, led by Royal Bank of Canada, which rose C$3.10 to C$51.60. But there is concern among industry analysts that the demise of income trusts as they exist today could ultimately affect the earnings at Canada's big banks by as much as 4.5 percent this fiscal year, and damage growth in the mutual fund industry, which has been buoyed by income trusts. American Investors Also Hit -------------- ¶9. (SBU) It is estimated that about 25 percent of investments (by value) in Canadian income trusts are held by international investors, of which 20 percent are U.S. investors. Canadian and international investors receive different tax treatments, based upon international treaties in place. For example, U.S. unitholders are subject to a 15 percent withholding tax on the distributions paid by income trusts. U.S. unitholders may elect to claim the 15 percent Canadian withholding tax on distributions paid during 2005 as a deduction against income, or subject to certain restrictions, as a credit against their U.S. tax liability. In any case, the tax benefit to U.S. investors will diminish with the change in tax treatment of income trusts. Analysts blame the tax advantages enjoyed by non-resident and tax-exempt investors in trusts as the driving force behind corporate conversions to income trusts. Political Ramifications -------------- ¶10. (U) The Liberals in Parliament hit hard at the Tories in Question Period on November 1 declaring the tax decision "a breach of trust." Liberal Finance critic John McCallum described the November 1 market fallout as "this day of infamy, this Black Wednesday." Canadian newspapers carried stories about how individual investors lost tens of thousands of dollars and who vowed to never vote Conservative again. On the other hand, it appears that many significant actors are in fact pleased with the federal government actions. In the halls of Parliament, both the NDP and Bloc Quebecois have said they will support the government's tax proposal. On the provincial front, the Liberal Finance Ministers of Ontario and Quebec were quick to praise the Tory decision. QOntario and Quebec were quick to praise the Tory decision. ¶11. (U) Regarding the "breach of trust" accusation, the Tories counter that their election promise not to alter the income trust tax regime had been intended to assure small investors, such as retirees, that they would be protected from a bigger tax bite. The Tories claim that there was no commitment to avoid taxing large corporate entities such as BCE and Telus, which had recently announced their restructuring to income trusts. To back these claims, Minister Flaherty introduced pension-splitting measures on October 31 to offset the new, higher, income trust tax rates for retirees. ¶12. (SBU) Some observers claim this GOC action demonstrates that the Tories possess a "Main Street" rather than a "Bay Street" mentality. However, several high-profile corporate chieftains had quietly approached the PM and Finance Minister in recent weeks to signal misgivings about the increased rate of corporate moves into income trusts. Sam Boutziouvis, the Vice President for Policy with The Canadian Council of Chief Executives, a business advocacy and policy group whose membership includes the CEOs of Canada's leading corporations (similar to the Business Roundtable in the U.S.) told the Embassy that over the past months they, too, have heard concern OTTAWA 00003333 003 OF 003 from their members about pressure to consider trust conversion. He also noted that the absence of comment from the corporate sector against the tax changes is an indicator that Corporate Canada is not going on the warpath against the Tories. Indeed, Don Drummond, a former Finance Ministry senior official and now Senior Vice President and Chief Economist for the TD Bank Financial Group commented, regarding the Tory action that, "on balance, it's clever". ¶13. (U) Comment: Given that the pain of the change is being felt by a relative few, and the decision is coming well before an election (anticipated for late spring/early summer 2007) and by which time the market will have likely bounced back, the Tories may in fact gain political strength by having demonstrated hard headed leadership. End Comment. ¶14. This cable was produced jointly by Embassy Ottawa, CG Toronto and CG Calgary.