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A fine start, Mr. Goodale, but your job's not quite done

The tax ruling does not level the playing field between trusts and firms, JACK M. MINTZ writes. Indeed, expect an explosion of trusts

Investors, corporations and trusts are elated with Finance Minister Ralph Goodale's decision to boost the tax credit on dividends paid by large businesses without levying a tax on income trust distributions.

As welcome as this change is, the policy thrown together at the last minute will not fully create neutrality between corporations and trusts. The minister's job is only partly done.

Businesses will find they are still better off to move into the trust sector to bypass corporate taxes rather than remain corporations. The trust market will grow significantly and the question will be when the minister's other shoe will drop after the dust settles with an election.

Wednesday's announcement makes a fundamental change to Canada's tax system -- and a good one at that.

Since 1972, the federal and provincial governments have provided individual investors a personal tax credit to offset corporate taxes paid on profits before they are distributed.

The credit provides full relief to owners of small Canadian-controlled private corporations that currently pay corporate taxes at about a 20-per-cent rate on their business income.

However, for owners of large corporations that are currently taxed at about a 35-per-cent rate, the dividend tax credit only provides partial relief. Thus, until yesterday's announcement, dividends paid by large and medium-size corporations were more highly taxed than other income.

For example, until the new system is in place, a high income earner pays corporate and personal taxes on dividends at a 56-per-cent rate (after accounting for the credit) while only paying a 46-per-cent tax on interest and other income.

Further, pension plans and RRSP owners pay no tax on investment income, so their tax on dividends is 35 per cent (the corporate tax) and nil for interest and other income.

This is why income trusts became so popular. By converting corporations into trusts, investors could avoid high tax rates on dividends in favour of a lower tax on trust distributions.

Income trusts are flow-through vehicles that allow investors to receive a mix of interest, dividends and capital gains as distributions.

Investors would then pay personal tax on trust distributions according to the income received, which tended to be primarily interest.

Trusts, therefore, accomplished something that has been available to small business owners receiving dividends with fully "integrated" corporate and personal taxes -- taxes paid on trust income would be similar to that on other income, including small business corporate dividends.

With yesterday's announcement, the discriminatory taxation of large corporate dividends will end.

Two dividend tax credits will be given to individual investors. Those receiving dividends from high-taxed income earned currently or in the future will be able to claim the high dividend tax credit that would fully offset corporate income taxes levied at a presumed 31-per-cent rate. This is expected to prevail, taking into account the mini-budget corporate rate cuts to be fully implemented by 2010.

Dividends paid by small businesses will only be eligible for the low dividend tax credit reflecting their 20-per-cent corporate income tax rate.

The new system will be complex, since dividends working their way through corporations will need to be tagged as to whether they are eligible for the high or low dividend tax credit.

For high income earners, their dividend tax rate will be cut such that investors will pay the same tax on corporate dividends as they would on capital gains and income trust distributions. However, for pension plans and RRSP earners, the new system will not affect them -- they will continue to prefer non-taxed trust distributions over corporate distribution, since the latter are still subject to corporate tax.

Non-residents will also prefer to own trusts rather than corporations since trust distributions will be taxed at a 15-per-cent rate rather than the much higher corporate and withholding tax rates on dividends.

Given that both of these investors have large pools of capital to invest in trusts, expect that the trust sector will explode now that the advance rulings can be given to provide them with certainty.

So while the Finance Minister has helped reduce the discriminatory taxation of dividends, he has only gone a small way to accomplishing his main objective of levelling the playing field between trusts and corporations.

The demand for trusts will continue unabated. And the game between the authorities and taxpayers is far from over. Jack M. Mintz is president and CEO of the C.D. Howe Institute and Deloitte & Touche professor of taxation at the J. L. Rotman School of Management.

© The Globe and Mail

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