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Income trusts--the new rules: new tax legislation levels the playing field between investments in corporations and income trusts.

Income trusts have been a popular topic of discussion in the business marketplace for several years. Market capitalization in these trusts increased over $100 billion between 2000 and 2005. Growing investor interest can be attributed to a low interest rate environment, higher-than-average cash distributions and, of course, attractive tax treatment.

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With a growing number of businesses using the income trust structure, there has been heavy speculation regarding the federal government's plans for the taxation of income trusts. In the 2005 federal budget, the Liberals raised concerns about the volume of investments in income trusts. Last fall, they announced changes to the rules for the taxation of dividends, intended to level the playing field between corporations carrying on business and the use of income trusts. The new Conservative government confirmed in the May 2006 federal budget that it would implement the Liberal's proposals; on June 29, it did just that.

Trust basics

Prior to the announcement of these rules, the taxation of business income in a corporation that wasn't eligible for the small business deduction wasn't integrated. Thus, earning business income in a corporation and then paying out the after-tax income as a dividend to the shareholders resulted in more tax than if the income was earned by an individual directly.

In recent years, income trusts have been used as a solution to this integration problem. A business income trust is generally structured to hold a combination of debt and equity of a corporation that carries on an active business. The income trust structure effectively allows investors to be taxed directly on business income earned by the trust and distributed to the unit holders.

The number of units for each trust are usually fixed and traded publicly. The trust capital that is raised is used to acquire the debt and equity of a business. Unit holders of the trust have the right to participate in the income and capital of the trust. Generally, most profits of the corporation are paid to the trust as interest or other deductible expense, so the corporation doesn't have taxable income. The trust distributes the income it receives, typically monthly or quarterly, so it too does not pay tax. Consequently, for most income trusts, the only tax paid is the tax payable by the investor on the trust income.

If the total amount of distributions received in a year exceeds the trust's income, the excess is a return of capital, which reduces investors' tax costs in the income trust.

Under the pre-2006 system, a dividend gross up and tax credit provided relief for the fact that a corporation pays dividends out of after-tax income. The gross up and credit was based on the assumption that the combined federal and provincial tax is 20%. However, this only applies to small business income; regular corporate income is taxed at a much higher combined rate, generally about 36% (depending upon the province). The combined personal and corporate tax is therefore significantly higher than what the personal tax would be if the income was earned directly by an individual. For example, an individual resident in Ontario would pay a combined tax rate of 56%, whereas income earned directly would have a top tax rate of 46%.

The federal government decided to deal with this issue by allowing "eligible dividends" to benefit from a much higher gross up and credit mechanism. Thus it introduced an enhanced gross up (45%) and dividend tax credit (27.5% of actual dividends) for eligible dividends. Non-eligible dividends are still subject to a gross up of 25% and a dividend tax credit of 16 2/3% of the actual dividend.

This new system is based on an assumed 32% corporate tax rate. The existing gross up and tax credit will continue to apply to ineligible dividends, such as those paid from after-tax small business income or after-tax investment income.

Since many corporations have different types of income and some corporations earn income that is subject to both the small business rate and the general rate, tracking different income types is challenging. Thus the government has announced eligible dividend rules: one set that applies to Canadian-Controlled Private Corporations (CCPCs) and a second set that applies to other corporations. These rules are generally effective as of January 1, 2006.

Eligible dividend rules--CCPCs

Since the first $300,000 of active business income ($400,000 in 2007) is subject to the federal small business tax rate, the new rules assume that all CCPC income will give rise to ineligible dividends. Thus the government has introduced a new tax account called the "General Rate Income Pool" (GRIP) for CCPCs with active income in excess of the limit for the small business tax rate.

This pool represents an accumulation of after-tax income taxed at the general rate. Since the rate of taxation is based on both federal and provincial rates, the government is simply assuming that the combined general tax rate is 32%. Therefore, each year, an amount equal to 68% of taxable income, excluding small business income and investment income, will be added to the GRIP balance.

As well, recognizing that corporations may have had general rate business income in the past, for their 2006 taxation year, CCPCs will be allowed to add an additional amount to the GRIP in respect of taxation years ending after 2000 and before 2006. This addition will again be based on taxable income--excluding small business income and investment income. Given that tax rates were higher in the past, the rules assume that this income was taxed at 37%, therefore the addition to the pool will be 63% of general rate income for those years.

When a CCPC pays a dividend, and it has a GRIP balance at least as large as the dividend paid, the corporation can choose to designate the full amount of the dividend as an eligible dividend. Shareholders who are individuals and trusts will therefore be eligible for the new dividend gross up and tax credit.

Since partial elections on a portion of a dividend can't be made, it will become more common to have multiple dividend declarations.

Eligible dividend rules--non-CCPCs

The rules for non-CCPCs are based on the assumption that the corporation wouldn't have any income on hand that was originally taxed at small business rates. However, this may not always be true, and therefore another new tax account--the "Low Rate Income Pool" (LRIP)--has been introduced. This account will track the after-tax small business income on hand.

Even though most non-CCPCs aren't eligible for the small business deduction, it is still possible for these corporations to have small business income on hand. Thus the LRIP will include:

* ineligible dividends received from other corporations;

* after-tax income of a credit union that qualified for the small business deduction; and

* where the corporation loses its status as a CCPC, an estimate of the amount of income earned prior to the change in status that was investment income or business income taxed at the small business rate.

Unlike the rules for CCPCs, non-CCPCs must clear out a LRIP balance before an eligible dividend can be declared. Therefore, ensuring the LRIP balance is correct will be crucial.

Given that shareholders will have no way of knowing whether or not a corporation was allowed to pay an eligible dividend in the amount received, the consequences of paying an eligible dividend that is too high will fall on the corporation. There is a penalty tax equal to 20% of the difference between the dividend and the GRIP balance at year-end.

Although these rules may be adjusted to address issues that arise before they are enacted, they should provide most of the details needed for federal tax purposes. However, to make integration complete, provincial tax on dividends must also be reduced. Quebec and Manitoba have announced that they will harmonize their provincial taxes and Ontario recently announced reductions to the taxation of dividends using a phased-in approach such that the full impact of the changes will not be realized until 2010.

For eligible dividends, the tax paid by a resident in Ontario for 2006 will be 25.09%, falling to 22.38% in 2010. The net result is that the total tax paid on high-taxed income earned through a corporation and paid to an Ontario resident--an individual taxed at the top rate--will be 52.15% in 2006, falling to 47.99% in 2010. When this is compared to a top tax rate in Ontario of 46.41% for income earned directly, it's clear that the proposed changes will help equalize the playing field between income trusts and direct share ownership.

George Vandebeek (gvandebeek@bdo.ca) is a partner of BDO Dunwoody LLP.
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Title Annotation:management trends
Author:Vandebeek, George
Publication:CMA Management
Geographic Code:1CANA
Date:Nov 1, 2006
Words:1446
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