The Trouble with Income Trusts
Available on SSRN.
This paper sketches broadly the efficiency and equity effects of income trusts that make their use as a substitute for the direct holding of shares problematic for tax policy purposes. The paper also considers the potential effectiveness of an equity recharacterization rule applicable to the high-yield subordinated junk debt that is the common feature of the basic income trust structure. The author suggests that this type of narrowly focused rule would be more target-efficient than other possible responses to income trusts, such as fundamental reform of the coporate income tax or restrictions on the holding of trust units proposed in the 2004 budget. However, a principal difficulty in designing an equity recharacterization rule is ensuring that it applies equally to structures that realize the same effect as the basic income trust structure but do not use high-yield junk debt. The author argues that income trusts are an example of tax-driven financial innovation in the sense that they replicate an existing set of securities and therefore have no non-tax rationale. These securities are essentially redundant, and the innovative process of which they are a product does not constitute "genuine" financial innovation. This essential characteristic of income trusts distinguishes them from real estate investment trusts, which arguably do not present a tax policy problem (or at least not the same one). In the absence of any efficiency gains or desirable distributional effects associated with income trusts, the available tax benefit is the subject of a defensible government response intended to eliminate it. But without any clear evidence that income trusts are substituted generally for the corporate form, any response can defensibly be limited to a narrowly targeted one that introduces a "tax law friction" by shifting the debt-equity boundary that is the focus of the basic income trust structure.