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On October 31, 2006, Minister of Finance Jim Flaherty announced the Tax Fairness Plan for Canadians. The cornerstone of the Plan is major reform to the tax rules applicable to certain publicly-traded trusts and partnerships, such as income trusts. The Plan also proposes a future reduction to corporate tax rates and changes that should improve the tax position of many seniors and pensioners.

The highlights of the Plan are:

• A new distribution tax will apply to distributions made by certain publicly traded flow-through entities, to be defined as Specified Investment Flow-Through Entities (SIFTs). The rate of the distribution tax payable will generally be equivalent to the combined federal and provincial tax that a Canadian corporation would have paid in similar circumstances. From an investor’s perspective, a distribution from a SIFT will be treated in the same way as a taxable dividend from a Canadian corporation. The new distribution tax will apply to existing SIFTs beginning in 2011, and to new SIFTs (those that begin public trading after October 31, 2006) in 2007 and thereafter.
• The general federal corporate tax rate will be reduced by a further one-half percent to 18.5% in 2011.
• The age credit available to Canadians aged 65 and older will be enhanced.
• Taxpayers will be allowed to “split” pension income with a spouse or common-law partner.

Background
In recent years traditional Canadian corporations have been moving increasingly to more tax-efficient “flow-through entity” structures (FTEs). This trend has accelerated significantly in recent months as more FTEs have been implemented and a number of significant Canadian corporations have announced plans to convert to FTEs.

Historically, FTEs were generally limited to broadly-distributed retail investment arrangements, such as traditional mutual funds, and to real estate investment trusts (REITs) and resource royalty trusts. More recently, FTEs have been extended to other sectors based largely if not exclusively on the distribution of earnings on a tax-efficient basis.

In November 2005, the previous government announced changes to the taxation of corporate dividends that were intended to “level the playing field” between traditional corporate distributions and FTEs. The objective was presumably “fairness” and slowing the trend to adopting FTEs.

The current government adopted these changes. However, the trend to forming FTEs did not slow and in fact accelerated and extended to larger traditional corporations, mainly because the initial changes did not address the advantages available to tax-exempt deferred income plans and non-resident investors in FTEs.

SIFTs
The proposed rules will apply to certain publicly traded trusts and partnerships that are SIFTs, as defined, that hold “non-portfolio properties” (other than certain REITs, as defined).

Non-portfolio properties will include certain investments in “subject entities,” Canadian resource properties, timber resource properties and real estate situated in Canada. Subject entities will include Canadian resident corporations, trusts and partnerships and non-resident corporations, partnerships and trusts whose principal source of income is in Canada.

A publicly traded trust or partnership that invests in a subject entity will be non-portfolio property if either the trust or partnership owns securities representing more than 10% of the fair market value of the “equity value” of securities of the subject entity or the subject entity represents more than 50% of the fair market value of the trust or partnership. In addition, any other property of the trust or partnership will be non-portfolio property if the investor uses the property in carrying on a business in Canada.

A REIT, as defined, will be excluded from the definition of SIFT and from the application of the proposed rules, provided it satisfies the following conditions:

• it must not, at any time in the year, hold non-portfolio property other than real property situation in Canada,
• at least 95% of its income for the year must be from properties,
• at least 75% of its income for the year must be attributable to rents from, mortgages on, or gains on the disposition of real
• property situated in Canada, and
• throughout the year, at least 75% of the value of the REIT must be attributable to real property situated in Canada, cash and debts and obligations of Canadian governments.

Real property situated in Canada will not include any depreciable property entitled to capital cost allowance at rate in excess of 5%.

Taxation of SIFTs
A trust that is a SIFT will no longer be entitled to deduct distributions of “non-portfolio earnings” to unitholders. Consequently, the SIFT will pay tax on such non-deductible distributions at the rate equivalent to the combined federal-provincial corporate income tax rate.

Normally, trusts are taxed at the highest personal income tax rate. If a SIFT distributes non-portfolio earnings to unitholders, the tax applicable to the SIFT in respect of such earnings will be reduced to the general federal corporate tax rate (21% in 2007, to be reduced to 18.5% by 2011) plus 13% for provincial tax.

Non-portfolio earnings will include income attributable to a business carried on in Canada and income from, or gains from the disposition of, non-portfolio properties.

The amounts distributed by a SIFT to investors, that are not deductible to the SIFT pursuant to the rules above and which are subject to the distribution tax, will be treated as taxable dividends from a taxable Canadian corporation to the recipient. A Canadian corporate recipient would generally be entitled to deduct the dividend received from its taxable income. A Canadian resident individual recipient will be entitled to a dividend tax credit, including the recently enhanced dividend tax credit. A non-resident recipient will be subject to withholding tax based on the rate otherwise applicable to Canadian source dividends.

A partnership that is a SIFT will also be subject to tax on its non-portfolio income on the same basis as a SIFT trust. Similarly, allocations of non-portfolio income will be treated as taxable dividends to the partners.

Transition
The proposed distribution tax and re-characterization of SIFT distributions as dividends will apply to new SIFTs (those that begin to be publicly traded after October 31, 2006) beginning in 2007 and to existing SIFTs (those which were publicly traded before November 2006) for their 2011 and subsequent taxation years. The effective date could be accelerated if a disproportionate amount of capital is inserted into an existing SIFT.

The government has also indicated that measures will be introduced with immediate effect in response to any emerging structures or transactions that frustrate the policy objectives underlying the proposed rules.

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