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Viewing cable 06OTTAWA3333, Income Trust Tax Loophole Closed

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Reference ID Created Released Classification Origin
06OTTAWA3333 2006-11-05 13:50 2011-04-28 00:00 UNCLASSIFIED//FOR OFFICIAL USE ONLY Embassy Ottawa
VZCZCXRO9881
PP RUEHGA RUEHHA RUEHQU RUEHVC
DE RUEHOT #3333/01 3091350
ZNR UUUUU ZZH
P 051350Z NOV 06
FM AMEMBASSY OTTAWA
TO RUEHC/SECSTATE WASHDC PRIORITY 4355
INFO RUCNCAN/ALL CANADIAN POSTS COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC
UNCLAS SECTION 01 OF 03 OTTAWA 003333 
 
SIPDIS 
 
WHA/CAN, EB/IFD/OMA, EB/IFD/OIA, EB/ESC/IEC 
 
State please pass to USTR (Mary Sullivan) 
 
USDOC FOR 4320/ITA/MAC/WH/ONIA (Walter Bastian, Geri Word) 
 
Treasury for International Affairs (Jasper Hoek) 
 
SENSITIVE SIPDIS 
 
E.0. 12958: N/A 
TAGS: EFIN EINV ETRD ECON CA
 
SUBJECT: Income Trust Tax Loophole Closed 
 
Sensitive But Unclassified - protect accordingly. 
 
1. (SBU) Summary: In a surprise move that sent Canada's financial 
markets reeling, the Canadian federal government announced on 
October 31 that it would start taxing income trusts as regular 
corporations.  The GOC took the action to stem lost revenue as more 
Canadian companies threatened to restructure themselves as low tax 
entity trusts.  Ottawa will start taxing newly formed Trusts as 
regular corporations as early as this year and existing trusts in 
the 2011 tax year.  Canadian financial markets responded November 1 
with the Toronto Stock Exchange (TSX) losing nearly C$24.5 billion 
in value from the trust sector; American investors hold about 20 
percent (by value) of the Canadian income trusts. Reaction from the 
opposition parties was split with the federal Liberals attacking the 
Tory decision, and the Bloc Quebecois and NDP supporting it. The 
Liberal finance ministers of Ontario and Quebec provinces also 
supported the move.  A growing consensus among political observers 
is that the Tories may in fact gain political strength in the coming 
months by having demonstrated tough leadership on this issue. End 
Summary. 
 
2. (U) Canada's Minister of Finance Jim Flaherty announced the 
measures on October 31 to "restore balance and fairness to the 
federal tax system by creating a level playing field between income 
trusts and corporations".  "Income trusts" - also known as 
publicly-traded flow-through entities (FTEs) - avoid most corporate 
taxes by distributing income to investors in monthly dividends and 
were intended to provide a tax break for non-commercial and 
portfolio investment trusts.  However, FTEs had been increasingly 
used by widely held and publicly-traded businesses to significantly 
reduce their tax burden.  Flaherty characterized the loss to federal 
and provincial tax coffers as "not appropriate." (the Province of 
Alberta estimated its net revenue loss due to income trusts to be 
about $400 million per year). 
 
3. (U) FTEs in Canada have grown dramatically in recent years and 
now represent over C$200 billion in market capitalization.  In 2006 
alone, corporations representing almost C$70 billion in market 
capitalization have either converted themselves into FTEs or 
announced plans to do so, including telecommunication giants BCE 
Inc. (based in Montreal) and Telus Corp (based in Vancouver).  In 
recent weeks, both companies had announced plans to become income 
trusts, which would have driven up the market value of trusts on the 
TSX by C$50 billion, resulting in an annual loss of C$800 million in 
 
SIPDIS 
tax revenue for the federal government. 
 
4. (U) The GoC intends to introduce a new tax regime for FTEs later 
this year under which their tax treatment will be more like that for 
corporations, and their investors will be treated more like 
shareholders.  In its news release on the tax changes, the 
Department of Finance claimed that Australia and the United States 
have "foreclosed the kind of inappropriate avoidance of entity-level 
tax that Canada's FTEs now exploit". 
 
TSX Takes a Nose Dive 
 
SIPDIS 
--------------------- 
 
5. (U) In reaction to the federal government's announcement, the 
Loonie fell eight-tenths of a cent against the U.S. dollar and the 
TSX experienced significant losses in trading on Wednesday, November 
 
SIPDIS 
1.  The TSX lost nearly C$24.5 billion in value from the trust 
Q1.  The TSX lost nearly C$24.5 billion in value from the trust 
sector (and would-be trusts), and the S&P/TSX composite index fell 
294 points (2.4 percent), the biggest single day loss in two and a 
half years.  The S&P/TSX Capped Income Trust Index fell more than 12 
percent, the most since at least 1998.  No trusts on the 73-member 
index rose on November 2.  The S&P/TSX composite index, however, 
closed up 80.34 points (0.7 percent) to 12,130.73 on November 2. 
 
Winners and Losers 
------------------ 
 
6. (SBU) Among the losers, CI Financial Income Fund dropped 20 
percent; Yellow Pages Income Fund fell 19 percent, and would-be 
trusts BCE and Telus lost 11 percent and 14 percent, respectively. 
BCE, Canada's largest communications company, experienced its 
biggest drop since 1983, when the company was formed. Though Bay 
Street was taken by surprise by the announcement, and industry 
insiders say that they were not consulted during the policy-making 
process, the consensus is that something needed to be done, 
especially in light of BCE's recent announcement that it would be 
converting itself into an income trust (see also para 12). 
 
 
OTTAWA 00003333  002 OF 003 
 
 
7. (U) Observers in Calgary, the hotbed of the oil and gas sector, 
suggest the new tax regime may lead to consolidation in the industry 
or greater foreign ownership of Canadaian natural resource entities, 
either through direct take-overs of trusts weakened by the new tax, 
or through their inability to acquire assets on their own.  CEO Bill 
Andrew of Calgary-based Penn West Energy said that he expects fewer 
corporate offices in Calgary, with less Canadian ownership in the 
oil patch in general; another Calgary firm compared the announcement 
to putting up a "for sale" sign on Canadian energy resources.  The 
Former CEO of Canadian energy giant EnCana, however, in a November 2 
op-ed piece for the Globe and Mail said the decision required "tons 
of courage" by the Government and that "in the long term, Ottawa is 
right to move on income trusts". 
 
 
8. (U) On Thursday, November 2, as the bleeding continued in the 
income trust sector, investors moved back into dividend-paying 
financial shares, led by Manulife Financial, up C$2.10 to C$38.40, 
after its better-than-expected results released the same day. 
Following closely behind Manulife were the Canadian banks, four of 
which marked 52-week highs, led by Royal Bank of Canada, which rose 
C$3.10 to C$51.60.  But there is concern among industry analysts 
that the demise of income trusts as they exist today could 
ultimately affect the earnings at Canada's big banks by as much as 
4.5 percent this fiscal year, and damage growth in the mutual fund 
industry, which has been buoyed by income trusts. 
 
 American Investors Also Hit 
--------------------------- 
 
9. (SBU) It is estimated that about 25 percent of investments (by 
value) in Canadian income trusts are held by international 
investors, of which 20 percent are U.S. investors.  Canadian and 
international investors receive different tax treatments, based upon 
international treaties in place.  For example, U.S. unitholders are 
subject to a 15 percent withholding tax on the distributions paid by 
income trusts.  U.S. unitholders may elect to claim the 15 percent 
Canadian withholding tax on distributions paid during 2005 as a 
deduction against income, or subject to certain restrictions, as a 
credit against their U.S. tax liability.  In any case, the tax 
benefit to U.S. investors will diminish with the change in tax 
treatment of income trusts.  Analysts blame the tax advantages 
enjoyed by non-resident and tax-exempt investors in trusts as the 
driving force behind corporate conversions to income trusts. 
 
Political Ramifications 
----------------------- 
 
10. (U) The Liberals in Parliament hit hard at the Tories in 
Question Period on November 1 declaring the tax decision "a breach 
of trust."  Liberal Finance critic John McCallum described the 
November 1 market fallout as "this day of infamy, this Black 
Wednesday."  Canadian newspapers carried stories about how 
individual investors lost tens of thousands of dollars and who vowed 
to never vote Conservative again.  On the other hand, it appears 
that many significant actors are in fact pleased with the federal 
government actions.  In the halls of Parliament, both the NDP and 
Bloc Quebecois have said they will support the government's tax 
proposal.  On the provincial front, the Liberal Finance Ministers of 
Ontario and Quebec were quick to praise the Tory decision. 
QOntario and Quebec were quick to praise the Tory decision. 
 
11. (U) Regarding the "breach of trust" accusation, the Tories 
counter that their election promise not to alter the income trust 
tax regime had been intended to assure small investors, such as 
retirees, that they would be protected from a bigger tax bite.  The 
Tories claim that there was no commitment to avoid  taxing large 
corporate entities such as BCE and Telus, which had recently 
announced their restructuring to income trusts.  To back these 
claims, Minister Flaherty introduced pension-splitting measures on 
October 31 to offset the new, higher, income trust tax rates for 
retirees. 
 
12. (SBU) Some observers claim this GOC action demonstrates that the 
Tories possess a "Main Street" rather than a "Bay Street" mentality. 
 However, several high-profile corporate chieftains had quietly 
approached the PM and Finance Minister in recent weeks to signal 
misgivings about the increased rate of corporate moves into income 
trusts.  Sam Boutziouvis, the Vice President for Policy with The 
Canadian Council of Chief Executives, a business advocacy and policy 
group whose membership includes the CEOs of Canada's leading 
corporations (similar to the Business Roundtable in the U.S.) told 
the Embassy that over the past months they, too, have heard concern 
 
OTTAWA 00003333  003 OF 003 
 
 
from their members about pressure to consider trust conversion.  He 
also noted that the absence of comment from the corporate sector 
against the tax changes is an indicator that Corporate Canada is not 
going on the warpath against the Tories.  Indeed, Don Drummond, a 
former Finance Ministry senior official and now Senior Vice 
President and Chief Economist for the TD Bank Financial Group 
commented, regarding the Tory action that, "on balance, it's 
clever". 
 
13. (U) Comment: Given that the pain of the change is being felt by 
a relative few, and the decision is coming well before an election 
(anticipated for late spring/early summer 2007) and by which time 
the market will have likely bounced back, the Tories may in fact 
gain political strength by having demonstrated hard headed 
leadership.  End Comment. 
 
14. This cable was produced jointly by Embassy Ottawa, CG Toronto 
and CG Calgary.