Jim Flaherty's canadian investment trust tax change

Eric Fry - Mon 06 Nov, 2006

...Why did Flaherty propose the shocking tax change? Because a couple of large Canadian telecoms were planning to convert into investment trusts, thereby dodging the taxes they would otherwise owe...

 
 
- When I first gazed at my Bloomberg screen Wednesday morning, I saw a stock quote that didn’t look quite right. One of the Canadian investment trusts that I monitor opened down 15% on the very first trade. "Must be a bad quote," I thought to myself.

- But it wasn’t a bad quote. It was just bad news. A wacky tax proposal from the Canadian Finance Minister, Jim Flaherty, triggered a massive rout of the country’s investment trust sector.

- It may be possible to view the rout as a buying opportunity – perhaps a phenomenal buying opportunity – but before jumping to rosy conclusions, let’s examine a few pertinent facts.

- Under current Canadian tax laws, investment trusts pay no corporate taxes, although distributions to shareholders are taxable. Under the Finance Minister’s new proposal, dubbed the "Tax Fairness Plan," this tax exemption would disappear.

- According to the proposal’s gruesome details, newly formed investment trusts would pay standard corporation taxes of 34%, dropping to 31.5% by 2011. Existing investment trusts would receive a 4-year holiday from taxation, but would begin paying standard corporate taxes in 2011. Flaherty also plans to raise dividend tax rates for pension funds and foreign investors that own trusts.

- Why did Flaherty propose the shocking tax change? Because a couple of large Canadian telecoms were planning to convert into investment trusts, thereby dodging the taxes they would otherwise owe. "This year alone," he gripes, "there’s been almost $70 billion in new trust conversion announcements. We have seen a growing trend toward corporate tax avoidance."

- Understandably, Flaherty had grown tired of watching one Canadian company after another convert itself into a tax-free entity. Less understandable is why he did not merely end the policy instead of proposing major retroactive changes to the tax laws.

- If he had merely ended the investment trust mechanism, he could have halted the erosion of the Canadian tax base, without also destroying $25 billion of shareholder wealth in a single day, shutting down the existing investment trust apparatus, violating the trust of every investor in Canadian assets, imperilling future investment in the country, eroding the Canadian government’s credibility, undermining the Canadian dollar and looking like an incompetent buffoon.

- If enacted, this proposal will not merely bite the hands that feed the Canadian economy, it will amputate them. Flaherty’s proposed retroactive tax reneges on longstanding agreements between investors and the Canadian tax authorities.

- As such, it is just as much an appropriation of capital as anything conceived by Venezuelan President, Hugo Chavez. (The Venezuelan president, you may recall, reneged on contracts with several foreign oil companies, causing them to pay much higher royalties and taxes, or abandon their projects).

- The policy seems so ludicrous and counter-productive that we wonder if it might be retracted. The sheer stupidity of the proposal, therefore, could be a good reason for buying an investment trust.

- Another possible reason for buying the battered investment trusts is that a fully-taxed investment trust is still an investment trust. In other words, it still offers a very high dividend yield, especially after yesterday’s shellacking. Hundreds of trusts now offer yields over 10%, and many offer yields of 13% and higher.

- Therefore, even after accounting for a tax hit as high as 34%, most trusts offer pro-forma yields between 7% and 10%, if our back-of-the-envelope calculations may be trusted.

- What’s more, the current yields are still the ACTUAL yields until 2011, when existing trusts must begin to pay the tax man. And even after 2011 arrives, investment trusts will not suffer equally under the new tax regime. Some will fare much better than others.

- Investors might sell just because the investment trusts are falling. They might swear off of Canadian investments like an AA newbie swears off Jagermeister shots. The Canadian dollar might also suffer more abuse, like it did today. The "loonie," as it is sometimes called, fell about 1% after the news.

- No prudent investor can afford to ignore these risks. In fact, most prudent investors will probably toss their hands in the air, shrug their shoulders and ask themselves, "Why bother?" We have no ready answer. But we suspect the selling has been overdone and could reward those who take the plunge.


Regards,

Eric Fry
for The Daily Reckoning