Canada: Relief for REITs

Copyright 2011, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Tax, January 2011

On December 16, 2010, the Minister of Finance announced proposed amendments to the provisions in the Income Tax Act (Canada) concerning real estate investment trusts (REITs). These changes are welcomed by the REIT industry because it will make it easier for a REIT to qualify for exemption from entity-level taxation under the specified investment flow-through rules (the SIFT Rules).


Prior to the introduction of the SIFT Rules, REITs and other mutual fund trusts operated as conduits for tax purposes. That is, they were generally not subject to tax; instead, their unitholders were taxed on income distributed to them. This gave rise to the proliferation of income funds which, in the view of the government, threatened the tax base.

The government responded with the introduction of the SIFT Rules on October 31, 2006. Under the SIFT Rules, publicly traded trusts and partnerships were to become subject to corporate-like taxation subject to transitional relief that ended on December 31, 2010 (or earlier if the SIFT issued equity in excess of the permitted thresholds under the "normal growth" guidelines).

The SIFT Rules contain an exemption for REITs that meet certain asset and revenue tests throughout the taxation year (Qualifying REITs). These tests were very restrictive and, in some respects, unclear. The consequences of not meeting all these tests, even for a moment or in an immaterial way, were significant as the REIT would not be exempt from taxation under the SIFT Rules for that taxation year. The REIT industry lobbied for changes and, with only two weeks remaining in the transitional relief period, the Minister announced the changes described below.

The Proposed Amendments

1. Qualified REIT Properties

Under the current rules, one of the tests to be a Qualifying REIT is that the trust may not hold any "non-portfolio property" other than "qualified REIT properties". The definition of "non-portfolio property" is intricate but suffice it to say that most of the assets of a typical REIT would be non-portfolio property. The definition of "qualified REIT property" is also complex but, generally, means real property, securities of certain entities (including entities that would meet the tests to be a "Qualifying REIT" even if they are not trusts) and property ancillary to earning rent and capital gains from the dispositions of real property.

The problem with this current test is that there is no leeway. The holding of even a single non-portfolio property that was not a qualified REIT property would result in the REIT not being a Qualifying REIT and losing its exemption.

The test will be amended so that up to 10% of the fair market value of all non-portfolio properties can be assets other than qualified REIT property. In the typical situation where the REIT operates through subsidiary entities, this 10% basket will apply to each subsidiary. This new 10% basket will provide flexibility to hold assets that were previously not permitted as well as a limited safe harbour for assets that may incorrectly have been thought to be qualified REIT properties.

A related amendment will, however, be restrictive in nature. In order for property ancillary to earning rent and capital gains to constitute qualifying REIT property, the property will have to be tangible personal property. For example, computers and office equipment used in the operations generating rents and capital gains would qualify. But intangible property such as debt would not qualify. Before this change, it would have been arguable that a vendor take-back mortgage was a property ancillary to earning a capital gain from the disposition of real property. Now, if the mortgage is non-portfolio property and is not issued by an entity that would meet the tests to be a "Qualifying REIT", the mortgage would not be qualified REIT property and would have to be held within the new 10% basket. The same would be true for a derivative, such as an interest rate swap, entered into to hedge a REIT's borrowing costs.

An amendment related to the introduction of the new rules on "eligible resale property" (see below) provides that real property will only be qualified REIT property if it is capital property. Accordingly, as noted below, eligible resale property will not constitute qualified REIT property and will have to be held within the new 10% basket.

It should be kept in mind that there is a second test to be a Qualified REIT, based on asset holdings, that is not being amended. This test provides that the value of real property, cash and certain near-cash assets must be at least equal to 75% of the equity value of the trust.

2. Revenue Tests

A REIT must meet two revenue tests in order to be a Qualifying REIT. The first is that at least 95% of the trust's revenues for a taxation year must be derived from rent from real property, interest, capital gains from dispositions of real properties, dividends and royalties. The second is that at least 75% of the trust's revenues for the taxation year must be derived from rent from real properties, interest from mortgages and capital gains from dispositions of real properties.

Under the proposed amendments, the 95% test will be changed to a 90% test. This is another change that will permit greater flexibility in operations.

Gains from dispositions of "eligible resale properties" (see below) will be added as a new category of qualifying revenue for the purposes of the 90% test, but not the 75% test.

For both of the revenue tests, there was uncertainty as to the meaning of "revenues". Under the proposed amendments, both tests will now be based upon "gross REIT revenue" which is defined to mean capital gains and any amount received or receivable that is not on account of capital. This confirms that recaptured depreciation is not included in the base amount of revenues to which these two percentage revenue tests apply. A capital loss does not appear to reduce gross REIT revenue. A technical issue with the new term is that gross REIT revenue appears to include the full proceeds of sale of "eligible resale property" rather than just the gains therefrom.

3. Eligible Resale Property

The proposed amendments introduce the new concept of "eligible resale property". The intention is that subsidiaries of REITs be permitted to hold a limited amount of real property that is held for resale, (i.e., inventory).

REITs, being mutual fund trusts, are not permitted to directly hold real property inventory, and this rule is not being changed. Rather, the proposed amendment will permit subsidiary entities of a REIT to hold eligible resale property but within, perhaps, overly restricted circumstances. The term "eligible resale property" is defined to mean real property (other than capital property) of an entity (e.g., a subsidiary of the REIT) at least partially owned by a listed entity (i.e., the REIT) provided:

(a) the real property is contiguous to real property that is capital property of the REIT or the other entity; and

(b) the holding of the property is necessary and incidental to the holding of such capital property.

As an example, a REIT subsidiary may plan to sever a portion of a shopping centre for resale to an anchor tenant with the intent that the balance of the shopping centre would continue to be held to generate rental income.

Eligible resale properties will not be qualifying REIT properties and, accordingly, will have to be held by the REIT subsidiary within the new 10% basket. This means, for example, that a REIT will not be able to use a special purpose subsidiary to develop or hold property for resale. Also, while gains from dispositions of eligible resale properties will be qualifying revenue for the purposes of the 90% revenue test, they will not be qualifying revenue for the purposes of the 75% revenue test. As noted above, the definition of "gross REIT revenue" appears to be deficient in that it includes the full amount of the proceeds of sale of eligible resale property rather than just the gains therefrom.

It appears that eligible resale property may not be owned by a subsidiary of a subsidiary of the REIT. This would be problematic for REITs that hold their real property in a limited partnership that is owned by a subsidiary trust of the REIT. As a matter of tax policy, it is not obvious why this should be the case.

4. Flow-Through Characterization of Revenue

REITs often operate through subsidiary trusts and partnerships. While, under the existing rules, the Canada Revenue Agency is of the view that the characterization of revenue earned by a partnership is retained when flowed through to the parent REIT, it accepts that only certain types of income (such as rent and capital gains) flowed through a subsidiary trust retain their characterization when received by the parent REIT. For example, interest earned by a subsidiary trust and distributed to the parent REIT was not regarded as interest of the parent REIT. This could have created problems for the parent REIT in meeting the two revenue tests.

Under the proposed amendments, revenues flowed through a subsidiary trust will retain their characterization for the purposes of the revenue tests.

5. Foreign Currency Gains and Hedges

Under the proposed amendments, qualifying revenue for the purposes of the two revenue tests will include foreign exchange gains in respect of qualifying revenue from a foreign country, such as rent from real property held in the United States, and in respect of debt incurred for the purpose of earning revenue from a foreign country, such as a Euro-denominated debt incurred to acquire real property in Germany. Further, the new rule will include in qualifying revenue amounts received under certain foreign currency hedging agreements in respect of the currency of a country in which the REIT holds real property. Interest rate hedges used in connection with financing real property holdings or to earn qualifying revenue are not covered by this proposal even though interest is itself qualifying revenue.

6. Closed-End Trusts and ETFs that Invest in REITs

Under the SIFT Rules, a listed trust, such as a closedend fund or an exchange-traded fund, would be a SIFT subject to entity-level taxation if the value of its "Canadian real, immovable or resource property" (CRIRP) represents more than 50% of the equity value of the trust. CRIRP includes not only direct holdings of real property and resource property located in Canada but also equity interests in entities (other than taxable Canadian corporations or SIFTs) that derive more than 50% of their value from such property. Accordingly, a closed-end trust or an ETF that concentrated its investments in Qualifying REITs would have been a SIFT subject to taxation under the SIFT Rules.

In response to lobbying efforts by such entities, the proposed amendments include a change to the definition of CRIRP. Interests in a Qualifying REIT will now be excluded from CRIRP so that such closed-end trusts and ETFs should be able to avoid taxation under the SIFT Rules. To make this amendment work properly, the definition of Qualifying REIT is being changed to provide that units of a Qualifying REIT must be publicly traded.

The definition of CRIRP will also be changed to provide that interests in SIFTs that are excluded from CRIRP will include interests in SIFTs while they enjoyed the transitional relief that ended on December 31, 2010.

7. Effective Date

Generally, the proposed amendments will apply to the 2011 and subsequent taxation years but a publicly traded trust may elect to have the new rules apply to earlier taxation years. This election would be of benefit to a REIT that would otherwise have been subject to tax under the SIFT rules before 2011 because it was not entitled to the transitional relief (for example, a REIT that was created after October 31, 2006 or a REIT that did not conform to the normal growth guidelines).

Issues Not Dealt With

While the proposed amendments offer considerable relief to the REIT industry, certain issues will continue to exist.

REITs that concentrate on hotels or seniors housing will not be Qualifying REITs. The U.S. approach of permitting such activities to be carried on by a taxable REIT subsidiary has been suggested to the Department of Finance but has not been adopted.

A Qualifying REIT must be structured as a trust. A partnership structure is not accommodated by the SIFT Rules. Under the SIFT Rules, a partnership that is a subsidiary of a REIT can itself be regarded as a specified investment flow-through entity (a SIFT), particularly where it has issued units exchangeable for units of the REIT to an investor other than a Qualifying REIT, a taxable Canadian corporation, a SIFT or a non-publicly traded entity entirely owned by the foregoing entities. Such a subsidiary partnership that is a SIFT would be subject to entity-level taxation as it cannot qualify for the exemption available to Qualifying REITs.

Certain assets should be qualifying REIT property rather than having to be held within the new 10% basket. Under the proposed amendments, tangible personal property that is ancillary to the earning of only rent and capital gains from dispositions of real property qualifies. Tangible personal property that is ancillary to the earning of interest, dividends, royalties and gains from dispositions of eligible resale property does not qualify even though these are also qualifying revenues for the purposes of the 90% revenue test. It is not clear why these properties should not qualify.

The tests that must be met to be a Qualifying REIT must be met throughout a taxation year. While the proposed amendments, particularly the new 10% basket and the more permissive revenue tests, will make it easier to qualify, if a REIT is offside on one of these tests at any time in a taxation year, it will not be a Qualifying REIT during that entire year. There is no rule that permits the REIT to limit entity-level taxation to only the part of the year it was offside.

Consultation Period

The Department of Finance has invited comments on the proposed amendments by January 31, 2011.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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