The tax advantages of the income trust structure may have contributed to business and market inefficiencies, Bank of Canada Governor David Dodge told a parliamentary hearing Thursday.
Mr. Dodge, testifying on the second day of the House of Commons Standing Committee on Finance's hearings into the federal government's proposed tax on income trusts, said that while “limited evidence suggests income trusts can enhance market completeness and market efficiency” by making higher risk/return products available to investors, the tax benefits of the structure had convinced some companies to convert to trusts for tax reasons, even if the structure wasn't the best for them “from a business efficiency point of view.” He said that from this standpoint, “The tax system was actually creating inefficiencies in the market.”
“[The trust structure] is definitely not appropriate [for companies] in areas where reinvestment and innovation are key,” he said. He suggested that the inefficiencies caused by such conversions constrained productivity of the companies involved, and that this would “eventually” erode the potential for productivity growth in the broader economy.
However, he acknowledged, “the Bank has done no specific research” on the impact of the trust structure on Canadian economic growth or productivity. “I'm speaking here on the basis of general principles,” he said.
Mr. Dodge was the biggest name on a high-profile list of witnesses testifying to the committee Thursday. The list included Manulife Financial president and chief executive Dominic D'Alessandro, economist Yves Fortin and BMO Capital Markets analyst Gordon Tait, as well as several well-known names from Canada's investment community and accounting profession.
The committee held its first day of hearings Tuesday. Finance Minister Jim Flaherty kicked off that lively session, in which he staunchly defended his tax plan and dismissed suggestions that he exempt energy trusts and/or extend the date that the tax would take effect beyond the planned 2011.
Mr. Dodge supported the government's efforts to remove the tax advantages of the trust structure, arguing that companies shouldn't select a business structure based on tax benefits. “You want to pick a structure that allows capital to be allocated to its most efficient use,” he said.
While he allowed that companies whose business is based on running down an existing asset — such as an oil well or a mine, for example — might not need reinvestment or innovation and therefore might find the trust structure the most efficient model, “In any other business . . . the income trust structure is not the appropriate structure to maximize the efficiency of capital.”
“It is absolutely critical that the tax system provides a level playing field,” Mr. Dodge said.
“Years ago, we should have realized that we had a bias here that could create a problem. But better late than never.”
Several other witnesses agreed that the bias in the tax structure in favour of trusts is inappropriate.
“The tax system was not neutral,” said Kevin Dancey, president and chief executive of the Canadian Institute of Chartered Accountants. “The status quo was not an option.”
“The government's proposal is a significant step in the right direction,” he said.
Mr. D'Alessandro of Manulife agreed that many companies were converting to trusts for the wrong reasons, and adopting a structure that discouraged reinvestment of capital. But he noted that many companies, including in the financial sector where Manulife operates, management and boards were under increased pressure to hive off parts of their company that looked attractive under a trust model. He noted that many parts of Manulife's operations fit this description.
“We would all, in time, have faced tremendous pressure to break up our businesses,” he said.
