Cablegate: Income Trust Tax Loophole Closed

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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

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---------------------

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

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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).

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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

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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.

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