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Tax Policy, , and Income Trusts

Benjamin Alarie and Edward Iacobucci

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Citation Benjamin Alarie & Edward Iacobucci, "Tax Policy, Capital Structure, (published version) and Income Trusts" (2007) 45:1 Canadian Business Law Journal 1-19.

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This article was made openly accessible by U of T Faculty. Please tell us how this access benefits you. Your story matters. THE REVUE CANADIAN CANADIENNE DU BUSINESS LAW DROIT DE JOURNAL COMMERCE Volume 45, No. 1 June/juin 2007

TAX POLICY, CAPITAL STRUCTURE AND INCOME TRUSTS

Benjamin Alarie and Edward M. Iacobucci*

I. INTRODUCTION While it can take various forms, a typical “income trust” is a form of business organization in which a trust owns all of the equity of a corporation (the operating entity) and the vast majority of the debt issued by the corporation. The corporation may owe some senior debt to an arm’s length party, but most of the operating corporation’s debt is owed to the trust. Investors in the trust own trust units which entitle them to elect trustees to oversee the management of the operating corporation. Financially, unit ownership entitles unitholders to a share of the income and capital of the trust. In substance trust units are like a stapled security, which is a share linked and traded together with a . There are three types of income trust structures in common use in Canada: business income trusts, energy trusts and real estate investment trusts.1 The first income trust structure in Canada was developed in 1985 by those behind the Enerplus Resources Fund, and approved in principle by the Canadian tax authorities the same year. Income trust structures have surged in popularity in the 11 years since the first business income trust was brought to market in 1995.2 In 1996, the market capitalization of energy, real estate and business income trusts combined was just $8.8 billion. By the end of 2000, the * Faculty of Law, University of Toronto. Thanks are owed to Anita Anand, Dan Awrey and Michael Trebilcock for helpful comments and suggestions relating to earlier drafts. 1. See Department of Finance, “Consultation Paper: Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partner- ships” (September 2005), available online at 5http://www.fin.gc.ca/activty/pubs/ flwthruent_e.pdf4 (accessed June 8, 2006), at pp. 3-4. 2. The first true business income trust was the Enermark Income Fund.

1 1 — 45 C.B.L.J.

Electronic copy available at: http://ssrn.com/abstract=1140321 2 Canadian Business Law Journal [Vol. 45 market capitalization had more than doubled to $18 billion.3 By the end of 2004, it had reached $118.7 billion.4 As of June 30, 2006 there were 247 income trusts listed on the (TSX), with a quoted market value of $195.4 billion.5 The quoted market value peaked in October 2006 at over $200 billion. Many observers believe that the income trust phenomenon has been almost entirely tax-driven.6 Indeed, out of a concern that the corporateincometaxbasewouldbeundulyerodedbyaseriesofhigh- profile conversions of publicly traded Canadian corporations to business income trusts,7 the federal Minister of Finance announced on October 31, 2006 that tax changes would be introduced to stem the tide. The planned (and contemplated) conversions of several large 8 9 Canadian corporations (such as Corp. and BCE Inc. ) were

3. See Department of Finance, supra, footnote 1, at p. 4. 4. Ibid. 5. See Toronto Stock Exchange, “Canadian Income Trusts”, available online at 5http://www.tsx.com/en/listings/sector_profiles/income_trusts/index.html4 (accessed August 28, 2006). 6. For example, Tim Edgar claims, “Income trusts are largely tax-driven structures that offer very little in the way of desirable efficiency or equity effects. In other words, they lack any significant consequential attributes that would otherwise justify their tolerance by tax policy makers.” See Tim Edgar, “The Trouble with Income Trusts” (2004), 52 Canadian Tax Journal 819 at p. 820. Paul Hayward states that Although non-tax considerations play an important role in the growth and proliferation of income trust structures, its popularity is largely attributable to the fact that a public company (or a company that is seeking to go public) can achieve significant tax savings by altering the legal form of the publicly held entity. By interposing a trust between the public investors and the operating corporation, the corporation may substantially reduce or eliminate corporate tax at the operating entity level and pass on those savings in the form of higher distributions to investors. See Paul D. Hayward, ‘‘Income Trusts: A ‘Tax-Efficient’ Product or the Product of Tax Inefficiency’’ (2002), 50 Canadian Tax Journal 1529 at p. 1531. 7. Note that this concern was not new. Indeed, out of concern that tax avoidance has motivated much of the growth of the income trust sector, the Department of Finance announced in September 2005 that the Canada Revenue Agency would be suspending advance tax rulings of income trusts and that it would be seeking submissions from the financial community relating to tax issues raised by income trusts and other flow-through entities. The submissions process was halted earlier than intended on November 23, 2005 when , the Minister of Finance at the time, announced that the federal tax credit would be increased to put publicly traded corporations on a more equal footing with income trusts. According to this plan, parity would be reached in 2010 provided the scheduled decreases in the corporate rate (from 21% in 2006 to 19% in 2010) occur as planned, the elimination of the corporate surtax goes ahead in 2008, and provinces match the federal enhancement of the credit. See Department of Finance, “Minister of Finance Acts on Income Trust Issue” (November 23, 2005) available online at 5http://www.fin.gc.ca/news05/ 05-082e.html4.

Electronic copy available at: http://ssrn.com/abstract=1140321 2007] Tax Policy, Capital Structure & IncomeTrusts 3 abandoned as a result of these changes. As they have been described by the Department of Finance to date, the changes will treat income trust structures as if they were corporations. The Department of Finance explains that, “the legal form a given business takes — whether as a corporation, a trust or a partnership — will come to depend less on the peculiarities of tax law, and more on the substantive business attributes of each of those structures”.10 The first major change imposes a withholding tax, essentially equivalent in terms of its rate to corporate income taxes, on distributions from income trusts to unitholders.11 A second change mandates that the distributions net of the first tax will be treated like in the handsof recipients. For existing income trusts the tax changeswillnot takeeffect untilthe 2011fiscalyear,butwhentherule changesareultimatelyenacted (asisnowwidelyexpected,thoughnot certain) the changes will be made effective retroactively to October 31, 2006 for all new income trust conversions. Instead of levelling the playing field between the corporate form and the income trust, however, these changes arguably go further to discourage the use of income trusts as high yield structures. If income trusts maintain high distributions in the aftermath of these tax changes (which is unlikely),12 more tax will end up being paid by unitholders than

8. Telus Corp. announced its intention to convert to an income trust on September 11, 2006. See Telus Corp., “Telus Announces Reorganization of Entire Entity into Income Trust” (September 11, 2006), available online at: 5http:// about.telus.com/cgi-bin/media_news_viewer.cgi?news_id=738&mode=2&- news_year=20064. See also Catherine McLean, “Telus extends its tax holiday with huge trust conversion: Shareholders to get a threefold cash boost”, Globe & Mail (September 12, 2006), p. B1. The company has since decided to not follow through on its conversion plans. 9. BCE Inc. announced its intention to convert to an income trust on October 11, 2006. The conversion proposal was expected to save BCE Inc. approximately $800 million annually in corporate income taxes. See BCE Inc., “BCE to be Wound Down, Bell Canada to Convert to Income Trust” (Press Release, October 11, 2006), available online at 5http://www.bce.ca/data/documents/conversion_- bell_press_release_en.pdf4. See also Catherine McLean, “BCE Dies, Bell Lives as a Trust”, Globe and Mail (October 12, 2006), p. A1. BCE Inc., like Telus Corp., has also abandoned its plans to convert to an income trust. 10. See Department of Finance, “Canada’s New Government Announces Tax Fairness Plan: Backgrounder” (October 31, 2006), available online at 5http:// www.fin.gc.ca/news06/Data/2006-061e.pdf4 at p. 3. 11. For details on the October 31, 2006 proposal, see the technical annex of the Department of Finance’s Backgrounder, ibid., at pp. 6-12. 12. Consider that upon announcing conversions to income trust form Telus Corp. announced an increase from $1.10 per share in dividends to $3.90 to $4.10 in distributions per unit of the trust. Similarly, BCE Inc. announced that it expected to distribute $2.55 per unit upon conversion, up from $1.32 per share in dividends prior to the conversion. 4 Canadian Business Law Journal [Vol. 45 shareholders in equivalent corporations, largely because they will lose out on the ability to control the timing of the relevant gains. It might appear that an analysis of the interactions between corporate finance and tax law in the income trusts context is now moot given that income trusts have had their days numbered by the federal government. However, this conclusion is unmerited. First, analysis of the interactions between corporate finance and tax law in the income trust context provides us with a clear way of assessing the likely impact of the recent reforms. An understanding of the significance of the income trust structure is necessary both to predict how the reforms will impact capital markets and normatively to evaluate the impact. For example, one of the implications of the analysis for the current reform is that the reform is not as neutral as the Department of Finance suggests. Income trusts will lose the ability to use the threat of the imposition of corporate income tax to make possible a greater degree of credibility in announced cash distribution policies.13 All other things equal, this consideration suggeststhatthereformwillreduceadoptionoftheincometrust.This may not be welcome from an efficiency perspective. Second, although it is likely that no new conversions will take place between now and 2011, existing income trusts will be around for at least another few years. In that time, tax law and policy will not stand still. It is possible that further relevant measures might be taken. In the process, the reforms might beundoneorredone ina differentway. Third, other countries have faced similar threats and responded in substantially the same way as has now been announced by the Canadian federal government. Other countries could very well face similar structures in the future. Thus, this analysis could inform debates elsewhere. This article analyzes the economic benefits and costs of the income trust vehicle for entrepreneurs organizing their business affairs. In doing so it examines the precise nature of the relationships between capital structure, income taxes and income trusts, reaching the conclusion that neither tax advantages nor corporate finance efficiencies alone are able to explain the market’s recent enthusiastic response to income trusts. The article proceeds as follows. Abstracting from the role of taxation, Part II outlines the economic incentives entrepreneurs have for using debt financing in

13. This point is expanded upon and explained in Part V, infra. The idea is that on arm’s length debt is essentially mandatory and that dividend payments to shareholders are entirely voluntary. Income trusts allow firms to retain income and not pay out distributions only at a significant cost — having to pay corporate income tax on the retained profits. 2007] Tax Policy, Capital Structure & IncomeTrusts 5 their capital structures. Part III focuses on the role of taxation in motivating entrepreneurs to choose debt financing. Part IV explains why entrepreneurs are motivated to select the most efficient organizational and capital structure for their businesses. Part V applies the foregoing analysis relating to economic efficiencies and tax advantages to the income trust phenomenon, in the process showingthatthetaxadvantagesassociatedwithincometrustscannot be understood without understanding the underlying economic efficiencies associated with debt financing, and that other economic efficiencies cannotbefullyunderstoodwithoutcontemplatingthetax considerations associated with debt financing. Part VI concludes.

II. OPTIMAL CAPITAL AND ORGANIZATIONAL STRUCTURE: FINANCIAL INCENTIVES TO RELY ON DEBT The choice of capital structure matters. To see this, it is helpful to begin with the contrary possibility. Modigliani and Miller famously showed that in perfect capital markets14 capital structure is irrelevant to the total value of a business.15 In such a world, capital structure simply divides up the cash flows generated by the business to different classes of investors, but does not affect the total value of the business.16 Modigliani and Miller would not, of course, insist on the irrelevance of capital structure in the real world.17 Rather, the irrelevance hypothesis serves as a useful point of reference for thinking about how capital structure affirmatively does affect the value of a firm.18

14. A perfect capital market is one with perfect information, no transaction costs, perfect competition, and no or non-distortionary taxes. 15. The original article showing this irrelevance result is Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investments” (1958), 48 Am. Econ. Rev. 261. In subsequent work, the authors demonstrate the role of relaxing some of these assumptions. See, for example, Franco Modigliani and Merton H. Miller, “Corporate Income Taxes and the Cost of Capital: A Correction” (1963), 53 Am. Econ. Rev. 433. See also Merton H. Miller, “Debt and Taxes” (1977), 32 J. of Fin. 261. 16. When asked whether he wanted his pizza sliced into four or eight slices, Yogi Berra is reputed to have responded, “Eight, I’m hungry tonight.” The absurdity of the response captures the intuition of the irrelevance hypothesis. 17. See the articles by Modigliani and Miller, supra, footnote 15. 18. Merton H. Miller has written, Skepticism about the practical force of our invariance proposition was understandable given the almost daily reports in the financial press, then as now, of spectacular increases in the values of firms after changes in capital structure. But the view that capital structure is literally irrelevant or that ‘‘nothing matters’’ in corporate finance, though still sometimes attributed to us (and tracing perhaps to the very provocative way we made our point), is far from what we ever actually said about the real world applications of our 6 Canadian Business Law Journal [Vol. 45 Aside from the role of distortionary income taxes, which is discussed in Part III, one important departure of the real world from the hypothetical perfect capital market relates to information. Investors do not have perfect information about the value of assets, nor do they have perfect information about managerial conduct. Where there is informational asymmetry between insiders and outsiders surrounding a business’s assets (“hidden information”),19 or where managers charged with running the business can engage in self-interested activity due to costly detection (“hidden action”),20 capital structure choices do not merely divide the stream of cash flows, but directly affect the market value of the business. It is easy to appreciate the impact of hidden information or hidden action on the choice to issue debt. Consider first the role of hidden information. Entrepreneurs often have more complete and less speculative information about the value of their businesses than outside investors as a result of extensive involvement in managing and overseeing the business. For entrepreneurs in need of capital to finance growth, there are several non-tax reasons why issuing debt may be more attractive than issuing equity. For one, issuing debt results in a pledge by the entrepreneur to give up control of the business in a costly bankruptcy proceeding if the business is unable to meet scheduled payments. To the extent that retaining control and avoiding bankruptcy is valuable, issuing debt signals the entrepreneur’s confidence in the firm’s investment opportunities. The ability to send a credible signal of the entrepreneur’s confidence in the business is valuable to the entrepreneur personally, but is also potentially socially valuable. The signal reveals information about the firm thatallowsinvestorstopricetheirinvestmentsinthebusiness more accurately, leading to greater capital market efficiency. Anothernon-taxreasonto issuedebt tofundthe newinvestmentin the presence of hidden information is that the alternative, issuing equity, would result in new investors having a share in the value of the

theoretical propositions. Looking back now, perhaps we should have put more emphasis on the other, upbeat side of the ‘‘nothing matters’’ coin: showing what doesn’t matter can also show, by implication, what does. See Merton H. Miller, ‘‘The Modigliani-Miller Propositions After Thirty Years’’ (1988), 2 J. Econ. Perspectives 99. 19. Ibid. See Stewart Myers, “The Capital Structure Puzzle” (1984), 39 J. of Fin. 575 and Stewart Myers and Nicholas Majluf, “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have” (1984), 13 J. Fin. Econ. 187. 20. The seminal article outlining the link between agency costs of debt and equity and capital structure was Michael Jensen and William Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure” (1976), 3 J. Fin. Econ. 305. 2007] Tax Policy, Capital Structure & IncomeTrusts 7 existing business as well as new business. Since new investors do not know the value of the existing business as well as the entrepreneur, they will be suspicious that any offer to share the residual claim is motivated by the entrepreneur’s private knowledge about the relatively low value of the existing business.21 When the entrepreneur issues debt, the entrepreneur retains the upside return associated with both the new and the old investment. This avoids the discounts that outsiders would insist upon if they shared equally in the upside of the existing business. It would be better for the entrepreneur to fund the newproject with retained earningsthan with equity, since financing growth this way would not involve the sharing of any of the risks of the business with new investors who are both less informed and suspicious of the entrepreneur’s reasons for seeking outside financing. However, where retained earnings are not available, debt can have private advantages for the entrepreneur and can also be socially desirable. Entrepreneurs might conceivably forego new investments if the only other option were to fund a new project by selling equity at a significant discount to its known value.22 Debt may also play a valuable role in addressing hidden action problems. Managers have considerable discretion when running a business. There is a danger that they will exercise this discretion by making decisions that bring private benefits to themselves but reduce the overall value of the business.23 Debt can be helpful in addressing the costs associated with the authority vested in the board of directors and management. These costs are commonly known as the agency costs ofequity.24 Wheneveranentrepreneursells equitytothird party investors, the entrepreneur is no longer the sole recipient of the residual claim in the corporation; rather, she shares in the residual claim with other shareholders. The smaller the entrepreneur’s residual claim, the greater will be the divergence between her

21. This is a version of the lemons problem popularized by George Akerlof, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism” (1970), 84 Quarterly Journal of Economics 488. 22. See Myers and Majluf, supra, footnote 19. 23. On this, Adam Smith wrote in The Wealth of Nations (1776) at Book V, Chapter 1, Part III, Article 1: The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. 24. See Jensen and Meckling, supra, footnote 20, at pp. 312-13. 8 Canadian Business Law Journal [Vol. 45 private and those of the shareholders collectively. Thus, the agency costs of equity are inversely related to the percentage of the residual claim that the entrepreneur retains. Selling debt rather than equity can preserve a block of equity in the hands of the entrepreneur and limit the agency costs associated with the sale of equity.25 In addition, a major concern for investors is that managers may invest cash flows earned by the business sub-optimally. For example, managers may use cash to fund excessive executive compensation, or to buy expensive art for executive offices.26 Such potentially sub- optimal uses of corporate assets may be beneficial for managers, but are undesirable for investors. Alternatively, managers may use excess cash to invest in projects that are not value-maximizing, but preserve or enhancethe size of the business, and do the same for the pay, power and prestige of the managers.27 Issuing debt addresses (to some extent) the agencycosts associated with available free cash flow. Debt commits managers to distribute cash to investors, and thus reduces sub-optimal use of cash by managers.28 Weighing against the advantages of issuing debt there are, of course, some countervailing considerations. First, while issuing debt can mitigate some agency problems, it can exacerbate others. In corporations, shareholders elect the board of directors. Directors interested in seeking re-election to the board will thus have reason to protect and promote the interests of shareholders. And because the board of directors in turn hires managers, there is reason to believe that managers will promote the interests of shareholders.29 Moreover, there is at least some legal authority for the proposition

25. See ibid., at pp. 333-37. 26. For a discussion of the abuses of delegated management, the story of the leveraged buy-out of RJR Nabisco in the 1980s is difficult to surpass. See Bryan Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (New York, HarperCollins, 2003), pp. 165-67. 27. This is sometimes, usually pejoratively, referred to as “empire building”. 28. On the disciplining nature of debt and its salutary effects in firms with considerable free cash flow, see Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers” (1986), 76 Am. Econ. Rev. 323. 29. This is consistent with the “shareholder primacy” model of corporate govern- ance, an early version of which was advanced by Adolf A. Berle, “Corporate Powers as Powers in Trust” (1931), 44 Harv. L. Rev. 1049. Note that the “director primacy” model of , which suggests that directors are the ones most suitable for making corporate decisions, has gained prominence in the literature following the decision of the Supreme Court of Delaware in Paramount Communications v. Time, Inc., 571 A.2d 1140 (1989). On the debate between proponents of shareholder primacy and director primacy generally, see D. Gordon Smith, “The Shareholder Primacy Norm” (1998), 23 J. Corp. L. 277 and Lynn A. Stout, “Bad and Not-So-Bad Arguments for Shareholder Primacy” (2002), 75 Southern Cal. L. Rev. 1189. 2007] Tax Policy, Capital Structure & IncomeTrusts 9 that managers are obligated to act in the best interests of shareholders.30 For these reasons, it is not unreasonable to posit that managers are likely to prioritize shareholders’ interests over those of debtholders. Agency costs of debt result from a conflict of interest between equity and debt.31 The residual claims of shareholders are subordinate to debtholders’ fixed claims on the corporation.32 Shareholders will have incentives to take on risky investments with high payoffs in some circumstances.33 If profitable circumstances emerge, the shareholders realize much of the upside through their residual claim. But if the investment fails to pay off, debtholders will bear much of the downside. In an insolvent corporation, for example, shareholders have an incentive to encourage management to make investments that are not value-maximizing in expected terms, but which in some circumstances would result in payoffs large enough to result in some surplus for shareholders. The more debt a corporation issues, the greater the tension between debt and equity and, generally, the greater the agency costs of debt.34 The commitment to pay out cash to debtholders can be a double- edged sword. If a business has profitable investment opportunities, retained earnings may be the readiest and most preferred source of capital. Retained earnings avoid the problems described above that result from issuing debt or equity when insiders know more about the value of the business (and new investment opportunities) than outside investors. Moreover, transaction costs are lower if financing is accomplished internally. However, investing out of retained earnings will not be possible if debt servicing obligations are too

30. See, for example, Dodge v. Ford Motor Co., 204 Mich. 459 (1919). But see Peoples Department Stores Inc. (Trustee of) v. Wise, [2004] 3 S.C.R. 461, 244 D.L.R. (4th) 564, 49 B.L.R. (3d) 165 sub nom. People’s Department Stores Ltd. (1992) Inc. (Re), where at para. 42 the Supreme Court of Canada remarked, “Insofar as the statutory fiduciary duty is concerned, it is clear that the phrase the ‘best interests of the corporation’ should be read not simply as the ‘best interests of the shareholders’. From an economic perspective, the ‘best interests of the corporation’ means the maximization of the value of the corporation.” 31. See Jensen and Meckling, supra, footnote 20, at pp. 333-37. 32. Some commentators have suggested that it is because shareholders are the residual claimants that they alone vote for the board of directors. Frank H. Easterbrook and Daniel R. Fischel, “Voting in Corporate Law” (1983), 26 J. Law & Econ. 395. 33. See Jensen and Meckling, supra, footnote 20, at p. 334. 34. Following Black and Scholes, it is possible to think of debtholders as having sold a call option to shareholders for the firm with an exercise or strike price equal to the claims of the debtholders on the firm. See Jensen and Meckling, ibid., at p. 336. 10 Canadian Business Law Journal [Vol. 45 demanding. Another cost of debt is that issuing debt increases the probability, and therefore the expected costs, of bankruptcy.35 Abstracting still from the relevant income tax issues whether a corporation should rely on debt or alternative methods of financing thus depends essentially on a variety of circumstances facing the business. For example, if potential problems of free cash flow are significant, as in mature industries that generate significant cash but little in the way of profitable investment opportunities, then a high degree of leverage may be optimal. On the other hand, if the business is likely to face significant growth opportunities, then limiting the commitment to pay out retained earnings by not issuing significant debt could be optimal.

III. TAX INCENTIVES TO RELY ON DEBT FINANCING Income tax systems, including the Canadian income tax system before the changes announced on October 31, 2006, generally allow deductions for interest expenses from business income regardless of the organizational form a firm adopts.36 Interest payments are then typically taxed in hands of the recipient investor.37 Therefore, in the ordinary case, interest is taxed once at the income tax rates applicable to each individual investor.38 In other words, interest gets “flow- through” tax treatment. In Canada, the rates imposed on interest income for individuals range from zero in the case of tax-exempt investorsorthoseearninglessthanthebasicpersonalamount,39 upto the highest combined marginal personal tax rate, which has in recent years hovered around 50% in most provinces.40 For business carried on by an individual as a sole proprietorship or

35. See Jensen and Meckling, ibid., at pp. 339-42. 36. In Canada, interest expenses are usually deductible from income from business or property so long as the expenses satisfy the conditions imposed by s. 9 and s. 20(1)(c) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.). 37. There are a few exceptions to this general treatment. For example, interest paid to tax exempt entities is not taxable; interest paid to nonresidents is typically subject only to a 25% gross withholding tax (or some lower rate prescribed by treaty). Interest paid to tax deferred entities is included in the recipient’s taxable income in a future taxation year, which can result in a considerable deferral advantage. 38. Of course, many lenders are corporations. Corporations receiving interest income will be taxed at the relevant corporate tax rate. 39. The basic personal amount is $8,148 for 2005. 40. The highest marginal rate is applicable in 2005 to those with taxable income in excess of $115,739. The combined federal-provincial marginal tax rates for interest and ordinary income for the 2005 tax year varied significantly from a low of 39% in up to 48.64% in Newfoundland and Labrador. The comparable rates in and were 46.41% and 48.22%, respectively. 2007] Tax Policy, Capital Structure & IncomeTrusts 11 through a partnership, business income also receives flow-through treatment. The business income of a sole proprietorship or partnership is allocated to the sole proprietor or partners, as the case may be, for each taxation year and is taxed at the individual level.41 Thus, much like interest deducted from business income under any organizational form, business income earned by sole proprietors or by a partnership is typically taxed once at the income tax rates applicable to the individuals, which again can range from an effective rate of zero up to nearly 50% in some provinces.42 Whenacorporationcarriesonabusiness,bycontrast,totheextent that the corporation uses equity financing there is typically not flow- through treatment of business income. Double taxation can result. Double taxation is particularly acute in “classical” income tax systems in which a corporation’s income is taxed (i) at the corporate level on an accrual basis as it is earned; and (ii) at the individual level on a realization basis when dividends are distributed to shareholders.43 In classical systems, even when corporations retain and reinvest their earnings, as they have an incentive to do, there remains the prospect of double taxation since capital gains are also subject to income tax (though typically at reduced rates).44 As a result of this prospect of double taxation, most income tax systems, including Canada’s, provide for integration of corporate and individual income taxes by taxing dividend income in a manner designed to reflect income taxes paid at the corporate level. In Canada, the relief on dividend taxation — the dividend tax credit — has historically fallen short of complete integration. Consequently,

41. See subdivision j of Division B of Part I of the Income Tax Act (ss. 96 through 103), entitled “Partnerships and Their Members”, and especially s. 96(1), which sets out the general rules pertaining to the taxation of partnerships. 42. This is not always the case. For example, corporations can be partners. A corporate partner’s share of partnership income would be taxed at the tax rate applicable to the corporation. 43. The United States has a “classical” income tax system in which there has traditionally been little relief for this double taxation. The result has been an even more severe problem with economic distortions driven by tax considerations. For some estimates of magnitude of the differential tax treatment of debt and equity in the United States see, for example, Roger H. Gordon and Jeffrey K. MacKie- Mason, “Effects of the Tax Reform Act of 1986 on Corporate Financial Policy and Organizational Form” in Joel Slemrod, ed., Do Taxes Matter?: The Impact of the Tax Reform Act of 1986 (Cambridge, Massachusetts, MIT Press, 1990); Jane G. Gravelle, Corporate Tax Integration: Issues and Options (Washington, D.C., Congressional Research Service, 1991) and Mark Gertler and R. Glenn Hubbard, “Corporate Finanical Policy, Taxation, and Macroeconomic Risk” (1993), 24 RAND J. Econ. 286. 44. R. Glenn Hubbard, “Corporate Tax Integration: A View from the Treasury Department” (1993), 7 J. Econ. Perspectives 115 at p. 115. 12 Canadian Business Law Journal [Vol. 45 debt has been tax advantaged relative to equity financing, and flow- through entities such as sole proprietorships and partnerships have been tax advantaged relative to the corporate form.45

IV. PUBLIC AND PRIVATE INCENTIVES TO MAKE STRUCTURAL CHOICES THAT MAXIMIZE VALUE Entrepreneurs have strong incentives to adopt value-maximizing capital structures, including the choice of organizational form. Suppose that an entrepreneur, who currently owns all claims on a corporation, is considering how to finance a particular valuable project. For the moment, assume that there are no taxes or other government influences on the choices. She has an incentive to choose a structure that maximizes value.46 If she chooses the optimal structure, the total value of the corporation is higher than if she chooses a sub-optimal structure. Since she owns all the claims on the corporation initially, she realizes any surplus after compensatingnew investors for the cost of advancing capital and will ultimately realize the returns personally from the optimal choice. Her pecuniary self- interest and society’s interests are well aligned. Even for seasoned corporations in which there is no sole owner, there is an incentive to choose optimally. Corporations compete in product markets. While no markets are perfectly competitive, many markets exhibit robust competition which will constrain financing choices. More specifically, if a corporation makes a sub-optimal financing choice, it will face a higher cost of capital. If it has higher costs than its rivals, its performance in product markets and eventually its existence will be jeopardized. Managers and existing investors, who have an interest in the firm’s survival, thus have some incentive to make optimal choices in financing the firm with a mix of debt and equity. Tax can (and does in practice) bias financing choices. If one kind of financing choice results in a lower tax burden for the business than another kind of choice, the entrepreneur (or managers in a competitive market) will weigh the following considerations: on the one hand, the decision-maker will account for the relative efficiencies of different capital structures; on the other, the decision-maker will determine the relative tax treatment of different structures. In a world where taxation matters, choices of organizational form and capital 45. This overstates the tax disadvantages for some Canadian corporations, however. For Canadian controlled private corporations (CCPCs), unlike publicly traded companies, the dividend tax credit offsets substantially all the income tax paid at the corporate level. 46. Jensen and Meckling, supra, footnote 20, at p. 345. 2007] Tax Policy, Capital Structure & IncomeTrusts 13 structure will depend in part on corporate finance considerations relating to agency and bankruptcy costs, and in part on tax minimization. The next part shows how the popularity of the income trust is attributable to both tax and non-tax considerations and, less obviously, their interaction.

V. APPLICATION TO INCOME TRUSTS This part discusses the trade-offs businesses face when deciding whether to adopt the income trust form or a traditional corporate structure, and how the tax system affects this choice. It begins by discussing the tax advantages of the income trust form and then discusses possible economic efficiencies arising from such a structure. The conclusion is that tax advantages of income trusts cannot be understoodwithoutunderstandingotherfinancingefficiencies,while other financing efficiencies cannot fully be understood without taking into account tax considerations.47 To begin, the tax advantages of the income trust rest on the aforementioned bias in the tax system relating to financing decisions: there is partial double taxation of earnings that eventually are paid out to shareholders, but only single taxation of earnings that are paid out to debtholders.48 As a result of this bias in favour of interest payments, the tax system generally encourages reliance on debt financing rather than equity financing. Observers commonly suggest that the popularity of the income trust results because of its reliance on leverage and the tax bias in favour of debt.49 Income trust structures, however, are of course not necessary to take advantage of the tax bias favouring debt. Corporations issue 47. The tax and non-tax aspects of the income trust phenomenon have been discussed in a number of academic articles, none of which identifies precisely the ways in which the tax and non-tax aspects of income trusts interact. For examples of this previous work, see Hayward, supra, footnote 6; Lalit Aggarwal and Jack Mintz, “Income Trusts and Shareholder Taxation: Getting it Right” (2004), 52 Canadian Tax Journal 792; Edgar, supra, footnote 6; Vijay Jog and Liping Wang, “The Growth of Income Trusts in Canada and the Economic Consequences” (2004), 52 Canadian Tax Journal 853. 48. In fact, the picture is more complicated than this short description suggests, since business income that is not distributed to shareholders and is instead reinvested in the corporation benefits from a deferral advantage to the extent that corporate income tax rates are lower than the average effective tax rates of shareholders. If dividends are not paid and shares are held long enough, capital gains taxes paid by shareholders may be lower under this system than under a flow-through system. 49. For an analysis of potential responses to the differential tax treatment accorded income trusts and a proposal for reform, see Jack M. Mintz and Stephen R. Richardson, “Income Trusts and Integration of Business and Investor Taxes: A Policy Analysis and Proposal” (2006), 54 Canadian Tax Journal 359. 14 Canadian Business Law Journal [Vol. 45 debt. To understand the contribution of the income trust to tax minimization, one must refer to the efficiencies and inefficiencies of different capital structures outlined above in Part II. If the minimization of income taxes were a business’s sole objective, leveraging the business to the point where all expected earnings are paid out to investors in the form of interest payments would be optimal.50 But we rarely observe entrepreneurs choosing capital structures where the value of debt is high and the value of equity is close to zero. This is because of the bankruptcy and agency costs that would be associated with such a structure.51 Expected bankruptcy costs are likely to be significant where equity has very little value. And in a case where the value of debt is very high and the value of equity is close to zero, equity holders would pressure directors into making risky investments that are not value-maximizing in expected terms, butwhichinsomecircumstanceswouldresultinpayoffslargeenough to result in some surplus for shareholders. The combination of expected bankruptcycosts andthe agencycosts ofdebt constrainsthe extent to which a corporation will issue debt.52 Income trust structures allow corporations to issue very high levels of debt without incurring significant bankruptcy costs or agency costs of debt. The key is that in income trust structures, unitholders of the trust are effectively both shareholders and subordinated debtholders. Since unitholders are debtholders, they would not want corporate managers to make investments that are value- reducing overall, but good for shareholders at the expense of debtholders. Moreover, given that the unitholders are functionally both shareholders and debtholders, if the corporation cannot make payments as theybecome due,the trust can renegotiatethe debt terms in a manner that preserves value without entering into costly bankruptcy proceedings that determine the relative claims of different classes of equity and debt. Since unitholders are effectively shareholders and debtholders at the same time, high levels of leverage can more completely take advantage of the tax bias in favour of debt without generating other costly problems. The general practice of third-party lenders to ignore subordinated intra- organizational debt for the purposes of loan covenants illustrates the 50. See Modigliani and Miller, “Corporate Income Taxes”, supra, footnote 15. For some subsequent refinements of this view, see Joseph E. Stiglitz, “Taxation, Corporate Financial Policy and the Cost of Capital” (1973), 2 J. Pub. Econ. 1 and Joseph E. Stiglitz, “The Corporation Tax” (1976), 5 J. Pub. Econ. 303. 51. On the role of bankruptcy costs in capital structure, see Joseph E. Stiglitz, “Some Aspects of the Pure Theory of Corporate Finance: Bankruptcies and Takeovers” (1972), 3 Bell J. Econ. 458. 52. See Miller, supra, footnote 18, at p. 113. 2007] Tax Policy, Capital Structure & IncomeTrusts 15 principle that the debt owed to the trust does not have the commitment of an arm’s-length obligation.53 Observers sometimes attribute actual efficiencies, rather than simply tax savings, to income trust structures because of the structure’s high degree of formal leverage.54 In particular, the commitment by income trusts to make regular distributions is alleged to reduce the waste that may result from corporate managers having access to cash (the free cash flow problem).55 Unlike simple debt, however, which also results in a commitment to pay out cash, the income trust accomplishes the commitment to distribute cash without creating perverse incentives for shareholders to make sub-optimal, risky investments at the expense of debtholders. It is worthwhile examining the alleged cash distribution advantages of the income trust in greater detail. It is not particularly clear what sort of commitment to distribute cash is associated with income trust structures. There is no reason in principle as a matter of contract law, or corporate or trust law for that matter, why the debt that the corporation owes to the trust cannot be renegotiated by the trust and the operating corporation. If, for example, corporate directors, who may also be trustees, believe there tobea valuableinvestmentopportunity,there isno presumptivelegal reasonwhytheycouldnotsimplyconvincethetrusttorenegotiatethe terms of the debt to reduce the rate of interest or defer payments indefinitely. That is, management of an income trust could use its business judgment to not pay out the cash that the nominal debt obligations would otherwise oblige it to pay. In short, unlike debt owed to a third party, the debt in income trust structures does not represent a hard commitment to disburse cash.56 Even in the absence of firm legal commitments to distribute cash to investors, there are other attributes of the trust that could help limit the agency costs of managerial access to cash. First, it could be that adoption of the income trust form conveys to investors a strong sense

53. See Edgar, supra, footnote 6, at p. 829. See also Michael R. King, “Income Trusts —Understanding the Issues” ( Working Paper 2003-25), available online at 5http://www.bankofcanada.ca/en/res/wp/2003/wp03- 25.pdf4 at p. 26. Although King does not mirror the point made by Edgar that debt owed to the trust is ignored by third-party lenders for the purposes of loan covenants, he does explain that analysts regard the “subordinated debt [owed to the trust] as quasi-equity”. 54. For discussion, see Hayward, supra, footnote 6, at p. 1535. 55. For a discussion of the agency costs associated with free cash flow, see Jensen, supra, footnote 28. 56. Of course, third party debt could also be renegotiated, but this would involve an arm’s length renegotiation as opposed to the intra-organizational renegotiation of an income trust’s debt. 16 Canadian Business Law Journal [Vol. 45 that managers intend to distribute cash to investors. Because of the signal it sends about the fundamentals of the business, there will be a negative market reaction to a failure to meet distribution obligations that could deter decisions to not pay out the cash. Of course, a corporation could announce a strong commitment to a high dividend policy, and would clearly suffer market sanctions from the failure to liveuptothismerelystatedintention.57 Nevertheless,itisconceivable that adoption of the income trust form sends a stronger signal about disbursing cash than a stated dividend policy of a corporation. It depends on the market’s expectations. For example, suppose that the market response to businesses that renege on a high dividend policy is a share price reduction of $10, but a reduction in unit price of $20 on income trusts that renegeby renegotiating corporatedebtowed to the trust. It would be rational for businesses to avoid adopting an income trust structure unless there was a stronger commitment to distribute income, and the greater market punishment for reneging income trusts may be rational given that the inability to maintain payouts despite the market’s harsh expected response is a stronger signal of weakness with the underlying business.58 While the signalling story is possible, a problem with the analysis is that there is no compelling theoretical reason to assume that the market has differing expectations regarding the stability of distributions versus dividends. A second reason why there may be a strong commitment to distribute cash in income trust structures relates to tax considerations. Consider first a corporation that announces a high dividend policy. Whether or not the corporation sticks to such a policy, all else the same, is irrelevant to the corporation’s corporate tax burden since dividends are paid with after-tax dollars. Now consider an income trust structure. If the corporate debt to the trust is renegotiatedtoasmallerpayout,solongastheoperatingcorporation has taxable income there will be an impact on corporate level income taxes: since interest expenses are deductible for the corporation, a

57. This theoretical point was make by Avner Kalay, “Signalling, Information Content, and the Reluctance to Cut Dividends” (1980), 15 J. Fin. & Quan. Analysis 855. See also Merton H. Miller and Kevin Rock, “Dividend Policy under Asymmetric Information” (1985), 40 J. of Fin. 1031. Empirical evidence shows that firms that announce an increase in regular dividends experience an abnormal increase in share price, and that this abnormal increase is not as large for announcements of special (i.e. non-recurring) dividends. See James A. Brickley, “Shareholders Wealth, Information Signalling and the Specially Designated Dividend: An Empirical Study” (1983), 12 J. Fin. Econ. 187. 58. On the other hand, to the extent that the market understands that income trust distributions are intended to reduce corporate income taxes (and not more) it might be possible that the negative signal sent by the decision to reduce distributions would be muted. 2007] Tax Policy, Capital Structure & IncomeTrusts 17 decision to reduce the payments increases taxable corporate income. Decreasing distributions may have negative tax consequences while decreasing dividends will not. Thus, the commitment to pay out cash is stronger in an income trust than in a corporation with a high dividend policy because of the differing tax treatment of interest payments and dividends. Differential tax treatment of the income trust has the consequence of allowing a business to commit better to paying out cash than an announced policy of paying high dividends. To summarize, there are both tax and efficiency motivations for the income trust. Theincome trusttakes advantageof the preferential treatment for debt under tax rules, while avoiding significant agency costs of debt andavoiding significant expected bankruptcycosts. The income trust may also have efficiency advantages resulting from a greater commitment by the business to distribute cash, though this stronger commitment relative to a high dividend policy depends in part on the differential treatment of debt and equity under tax law.

VI. CONCLUSION The conventional account of the income trust phenomenon holds that income trust structures provide a roundabout way to achieve the full integration of personal and corporate taxes, while at the same time retaining the non-tax advantages of the corporate (or ) form for the operating entity. Insofar as it goes, this is almost certainly correct. However, it is an incomplete picture of the forces shaping the recent popularity of income trust structures in Canadian capital markets. The more complete description is that income trusts allow a high degree of leverage — something available even without an income trust structure —without the attendant agency and bankruptcy costs. In addition, the differential tax treatment of income trusts and corporations implies a firmer commitment for an income trust to pay out cash than a corporation with a high dividend policy. Differential tax treatment creates both tax and agency cost incentives to adopt an income trust structure. The Department of Finance’s announcement on November 23, 2005 that the dividend tax credit would be enhanced worked to reduce, but did not eliminate, the incentives for publicly traded Canadian corporations to convert to an income trust structure.59 59. Under the changes announced in November 2005, the effective combined marginal corporate and personal tax rates on dividends for taxable investors is expected to become the same as the marginal rate of taxation on interest payments by 2010. This will be the case assuming that the announced decreases in corporate income tax rates continue through 2010, that the corporate surtax is 18 Canadian Business Law Journal [Vol. 45 This initial approach reduced the incentive for publicly traded Canadian corporations to convert to income trust structures for two reasons: (i) the enhanced dividend tax credit significantly lessened the biasinthe taxsysteminfavourofdebtfinancingfortaxableinvestors; and (ii) the commitment to pay out cash would be weaker in income trusts post-reform because of greater integration between corporate and personal income taxes. Importantly, however, these altered incentives applied principally to taxable, Canadian-resident investors. There were some investors — tax deferred, tax exempt, andnon-resident—forwhomincometrustsremainedmoredesirable investments than corporate equity.60 These continuing incentives engendered an additional $70 billion of announced trust conversions in 2006.61 These conversions, in turn, led to the announcement by the Department of Finance on October

eliminated in 2008, and assuming the cooperation of the provinces in enhancing their dividend tax credits. If all investors were Canadian-resident taxable investors, this in turn implies corporations would no longer have a tax incentive to choose debt over equity, or to choose an income trust form over the corporate form, since market prices for debt and equity, and hence proceeds to the corporation, would not be affected by tax considerations. Of course, however, not all investors are Canadian-resident taxable investors. 60. Tax-deferred investors would be willing to pay a premium for units of income trusts over corporate equity, because with income trust investments the drag of corporate income taxes can be avoided entirely. If tax-deferred investors drive up the price of income trust units through the willingness to pay this premium, the increase in the dividend tax credit would not eliminate the tax incentives for businesses to adopt (or retain) the income trust form over traditional corporate equity because the cost of income trust capital will be lower than the cost of equity capital. Nonresident investors face similar incentives. Withholding tax on trust distributions to nonresidents is generally imposed at a rate of 25% in the absence of a treaty under s. 212(1)(c) of Part XIII of the Income Tax Act. By treaty, the rates are often significantly lower. For example, the Canada-U.S. Tax Convention and the Canada-U.K. Tax Convention both reduce the statutory withholding rate to 15%. Nonresident investors cannot take advantage of a higher dividend tax credit and therefore will continue to face a tax advantage in investing in Canadian income trusts over Canadian corporations. Typically, because of foreign tax credits which are a feature of most domestic income tax regimes (e.g. § 901 of the U.S. Internal Revenue Code), nonresident investors will be indifferent to the effects of the withholding rate on trust distributions so long as it remains below the rate at which they will be effectively taxed in their jurisdiction of residence. This indifference condition is violated when nonresi- dents are themselves tax-deferred or tax-exempt entities in their home jurisdic- tions (e.g., private colleges in the United States), or where the jurisdiction of residence has low effective rates of income tax (i.e., tax havens). While there are frequently limits on the extent to which nonresidents can invest in income trusts, it is possible that a disproportionate proportion of foreign portfolio investment in Canadian equity markets, particularly from residents of countries with which Canada has tax treaties, will be made in income trust units. 61. See Department of Finance, supra, footnote 10, at p. 1. 2007] Tax Policy, Capital Structure & IncomeTrusts 19 31, 2006, that additional measures (the distributions withholding tax and dividend treatment for distributions) would be taken to more completely level the field between publicly traded corporations and income trust structures.62 A complete efficiency analysis of the recently announced tax reform is beyond the scope of this article. Some observations, however, follow directly from the preceding analysis. More consistent tax treatment of businesses on the basis of underlying business characteristics will obviously result in less tax-driven variation in the choice of organizational form. To the extent that tax considerations have driven the adoption of potentially inappropriate forms, the reforms are a welcome development. On the other hand, there will also be a loss associated with this more consistent tax treatment of income trusts and corporations that is widely ignored. Eliminating the differential tax treatment of income trusts and corporations will mean that the commitment of income trusts to pay out cash will no longer be firmer than that of a corporation with a high dividend policy (and will not be as firm as an obligation to pay interest on arm’s length debt). That is, corporate finance considerations, like the agency costs of debt and bankruptcy costs, explain why income trusts were key in allowing businesses to maximize the tax advantages of debt, while tax considerations help to explain the corporate finance attractions of the income trust. Reform jeopardizes these potential financing efficiencies. If and when the recently announced changes are enacted, Canada will join Australia and the United States in not only having endured an explosion of interest in publicly traded flow-through entities, but also in having addressed the issue by restoring more equal tax treatment to publicly-traded corporations and publicly traded flow- through entities. Given the significant incentives other major income tax systems exhibit for debt versus equity financing, it would be surprising if Canada is the last jurisdiction to have to cope with these issues.

62. Draft legislation was released by the Department of Finance on December 21, 2006. It was not, however, included in the Notice of Ways and Means Motion in the March 19, 2007 federal budget.