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Income trusts still the better tax deal

This past summer, my good friend Cary and I went on our annual camping trip to Algonquin park. On the first night, we pitched our new high-tech tent under the stars. In the middle of the night, I woke Cary up.

"Cary, look up at the stars. Tell me, what do you think?" I asked.

Cary replied: "I see millions of stars, and if there are millions of stars, and if even a few of those have planets, it's quite likely there are some planets like Earth, and if there are a few planets like Earth out there, there might also be life."

Then I replied: "Cary, that's not what I was thinking. Look again, somebody stole our tent!"

There we were, unexpectedly exposed. And if you're a Canadian investor who has relied on income trusts over the past few years, you've probably been feeling unexpectedly exposed too. Exposed to the risk that a portion of your portfolio could be soured by a simple stroke of the government's pen. Well, today there's good news for income trust junkies.

The theory

In my Sept. 24 article, I spoke about the Finance Department's overreaction to the perceived tax "leakage" resulting from trusts. After consultations, it's good to see that saner heads have prevailed.

Last Wednesday, Finance Minister Ralph Goodale announced proposals that would see the issue of income trusts dealt with in the proper manner -- by equalizing the playing field so that common shares will, in theory, look as attractive from a tax perspective as income trusts. The theory is that this will calm the demand for income trusts, which for various tax-driven reasons caused Mr. Goodale to lose sleep at night.

The proposal will see a reduction in the overall tax on "eligible dividends," which will generally include dividends paid after 2005 by public corporations (and certain other firms) that are resident in Canada. This will be accomplished by increasing the dividend "gross-up" from 25 per cent to 45 per cent for eligible dividends, and increasing the federal dividend tax credit to 19 per cent of the grossed-up dividend, up from 13.3 per cent.

In its news release this week, Ottawa showed that, in theory, the total tax paid by a public corporation, plus the tax paid by the shareholder on dividends received from the corporation, should be identical to the tax paid by the person who invests in the same business structured as an income trust. Problem solved.

The practice

But theory is never perfect. In this case, there will still be a tax advantage to income trusts. Consider an an Ontario resident, in the highest marginal tax bracket in 2006.

Under the new proposals, if this person invests in the common shares of a business -- call it XYZ Corp. -- and XYZ earns $10,000 of income in Ontario, the firm will pay taxes of $3,612 in 2006, leaving $6,388 to be distributed as a dividend to our investor. The investor will then pay tax of $1,353, leaving the investor with $5,035 cash in his pocket after taxes. This is much better than cash in his pocket of $4,156 under the current rules.

If our investor instead chooses an income trust that earns $10,000, the $10,000 of income will be fully taxed in the investor's hands, resulting in $4,641 in taxes, and $5,359 in his pocket after taxes. The result is similar in other provinces. Our investor will be better off with the income trust, which you know is going to help trust valuations.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

Levelling the playing field

Large corporations
CurrentProposedIncome trusts
Corporate tax
A. Income$10,000$10,000$10,000
B. Corporate tax$3,612$3,612-
C. Amount distributed to investor $6,388 $6,388 $10,000
Personal tax
D. Amount included in income $7,985 $9,263 $10,000
E. Personal income tax$3,706$4,299$4,641
F. Dividend tax credit $1,474$2,946-
G. Net personal income tax$2,232$1,353$4,641
Total taxes paid (B+G)$5,844$4,965$4,641
Cash in your pocket (C-G)$4.156$5,035$5,359
Assumptions for 2006 tax year
Investor resides in Ontario
General corp. tax rate 36.12%
Personal marginal tax rate46.41%
Current fed. dividend tax credit*13.33%
Current prov. dividend tax credit *5.13%
Proposed fed. dividend tax credit* 19.00%
Proposes prov. dividend tax credit* 12.80%

* of grossed up dividend


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