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Canada’s trust tax regime under scrutiny Growing federal tax losses and shrinking productivity blamed on energy income trusts; finance minister wants ‘early’ changes By Gary Park Petroleum News Canadian Contributing Writer
Precision Drilling, Canada’s largest drilling contractor, has caved in to the lure of the income trust sector, coinciding with renewed pressure on the Canadian government to change the way it taxes the trusts.
With announcements of new trusts and conversions occurring almost on a daily basis, the Canadian government has broken months of silence by asking the public whether it favors ending the favorable tax treatment of trusts.
It now estimates that trusts cost about C$300 million in lost tax revenues last year — at least five times greater than its earlier estimates.
Others think that figure was even higher. Based on a 2004 study, the C.D. Howe Institute, an independent think-tank, calculated that federal tax revenues would take a C$540 million hit when trusts carried a market value of C$80 billion. Now the market-cap sits at C$170 billion.
“Revenue loss is an issue when it gets into the realm of hundreds of millions of dollars,” Finance Minister Ralph Goodale said in Vancouver Sept. 9. Overhaul would raise public ire But it is far from clear whether that issue is large enough for the government to embark on a sweeping overhaul and face public wrath.
Don Drummond, chief economist at the Toronto-Dominion Bank, said the government is “obviously very worried” about the trend that has seen 22 Canadian companies either join the trust fold this year or propose conversion, with energy companies leading the charge. Those same 22 companies paid close to C$400 million in taxes last year, most of which will disappear under the trust structure.
A new Finance Department report released Sept. 7 said income trusts have soared in popularity in recent years because of a “low interest rate environment, the attractiveness of the tax treatment of flow-through entities, investors’ desire for cash distributions and high commodity (oil and gas) prices.”
The provincial governments of Alberta, Ontario, Quebec and Manitoba have added to the frenzy by implementing liability legislation, dealing with investor concern over their potential personal liability resulting from their investments in trusts.
In addition, Standard & Poor’s plans to include certain trusts in the S&P/Toronto Stock Exchange benchmark index by March 2006, improving the ability of trusts to raise funds. Government looking at various changes The Finance Department’s review, starting with the release of a consultation paper, will cover the possibility of applying corporate tax rules to trusts, limiting the ability of trusts to deduct interest expenses and, most dramatic of all, creating a neutral tax system that combines personal and corporate rates.
Goodale told reporters his government is giving priority to holding discussions with the business and tax communities “so we can get public policy right as early as possible.”
He said changes are needed because of lost revenue and to ensure both tax fairness and growth in productivity.
Federal officials expect the current round of talks will stretch well into 2006 before the government can start to reshape policy.
Howe Institute President Jack Mintz said there could be “quite a dramatic impact on the tax system if (the review) ends up leading to a new approach in handling shareholder taxation.”
Publicly traded corporations in Canada are currently taxed on their income and their shareholders are taxed on the dividends distributed. The corporate tax paid by trusts is sharply reduced because the bulk of taxable income is directed to unit holders.
Mintz said the tax laws are forcing companies into trust conversion, regardless of whether their business models are designed for the structure.
He said trusts, after distributing upwards of 90 percent of their cash flow to investors, have little cash left over to reinvest in capital equipment needed to increase productivity — a key barometer of economic health in which the United States is far ahead of Canada. Stampede to trusts From a quiet beginning in the late 1990s, the stampede to trusts has spread well beyond resource companies to a full spectrum of conventional companies, with uncalculated consequences for the government’s ability to finance its operations.
However, with many trust unit holders placing their investments in tax-sheltered retirement savings plans, Margaret Lefebvre, executive director of the Canadian Association of Income Funds, argues that Ottawa will collect the taxes as retirement plans are dismantled.
She described the difference as one between “tax forfeited and tax deferred.”
In confirming its anticipated switch to a trust, Precision set aside the misgivings of its founder and Chief Executive Officer Hank Swartout and accepted reality.
Even Swartout, who has described trusts as a “financial creation” of the government, conceded that the drilling and services sector is entering new territory.
“The demand right now is unprecedented … it’s a real frenzy to get the drilling done,” he told a conference call.
“The market is so hot in Canada now it’s hard for us to comprehend. It’s a very unique period of time.”
Precision, although planning to distribute 70 percent of its cash flow to investors, still plans to expand its rig fleet of 226 drilling rigs and 241 service rigs by about 10 percent over the next 16 months.
It is also prepared to use its trust units to make acquisitions, Swartout said. Precision sold divisions in June The road to a trust was more clearly laid out in June when Precision sold its international and technology divisions to Houston-based Weatherford International for US$2.28 billion and followed that by selling its shares in CEDA Holdings, a subsidiary that provides a wide range of services to Precision, for C$273 million to a private purchaser.
Swartout, despite his view that trusts are “not the best thing for Canada,” virtually described Precision’s move as a slam dunk.
However, he has said that if corporations could distribute their dividends tax-free like trusts they could compete on the same footing and “we’d be fine.”
While some have described the trusts as a black hole of mediocrity, Swartout represents a shrinking world of oil patch entrepreneurs, having parlayed a C$1 million investment into a company carrying a market value of more than C$7 billion.
Almost three years ago he warned that the emphasis on putting cash flow in the hands of investors rather than back in the ground had slashed upstream spending by C$1.2 billion-$2 billion a year.
A likeminded hard-driving industry leader, Murray Edwards, sounded off earlier this year about the impact of trusts on the capital investment needed to boost Canada’s energy output.
He also suggested the Canadian government should consider changes to the favorable tax treatment enjoyed by trusts.
But John Dielwart, chief executive officer of ARC Energy Trust, which produces about 55,000 barrels of oil equivalent per day, argues that many trusts such as his own have increased oil and gas production by concentrating their spending on developing existing wells.
“We’re not spending exploration dollars, but we are spending development dollars,” he said to those who accuse the trust sector of merely draining reserves.
Gordon Kerr, chief executive officer of Enerplus Resources Fund, said trusts are more than just a tax vehicle.
He said trusts are directing a lot of technology and energy into exploiting properties.
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