On Halloween October 31, 2006, the Minister of Finance surprised Bay Street by announcing a proposal that would significantly affect the taxation of income trusts. The intention behind the proposed changes was to discourage corporations from operating as income trusts and consequently eroding the Canadian tax base. One of the major criticisms of the proposal is that it deviates from the government’s commitment to allow income trusts to be taxed on more favourable terms than corporations. The government’s position is that non-residents and tax-exempt entities are unfairly benefiting from the pre-election promise to adjust the taxation of dividends when this is inconsistent with the object and spirit of the Act as a whole. This position appears to be inconsistent with pre-election promises to maintain the tax status of these entities. The government obviously believed that protecting the fiscal coffers was a lot more important than the perception that they would follow through with its election promise.
Essentially, the proposal creates a new tax regime for publicly listed flow through entities by imposing a distribution tax. The distribution tax prevents the deductibility of certain payments made by publicly traded income trusts and subjects all distributions from the income trust to the prevailing corporate rates at the time of the payment. The proposal provides a four year grace period that will ensure that existing income trusts will not be immediately affected by the change in rules. However, any income trust created after the announcement date will be subject to the new rules effective for the 2007 taxation year.
As part of this announcement, and presumably as a buffer for heightened criticisms from the public, the government also included in the proposal a decrease in the general corporate income tax rate of 0.5% effective in 2011. This proposal is an extension to amendments previously made by the former government, which would have decreased the corporate income tax rate beginning 2007 until 2010.
Taxation of investors under the proposal will be affected. For example, distributions to:
(1) Canadian resident individuals will be deemed to be eligible for enhanced dividend tax credit;
(2) Canadian-resident corporations are deductible from the recipient’s income;
(3) RPPs, RRSPs, RRIFs are not taxed and the tax exempt entities are not entitled to any refundable dividend tax credit; and
(4) Non-residents are subject to withholding tax.
For more information and updates on legislative proposals on how the distribution tax will apply to flow through entities, visit the Department of Finance’s website.