Originally published in Blakes Bulletin on Tax, January 2008
On December 20, 2007, the Canadian Government released legislative proposals to correct some (though not all) of the anomalies in the "SIFT" legislation originally announced October 31, 2006, and enacted earlier in 2007.
The SIFT legislation imposes an entity-level tax at rates approximating corporate income tax rates on the distributed non-portfolio earnings of trusts and partnerships that are "specified investment flow throughs" or "SIFTs". Generally speaking, publicly-traded income trusts, energy trusts and limited partnerships come within the definition of a SIFT. Real estate investment trusts (REITs) are intended to be excluded from this new regime. Unfortunately, the SIFT legislation, like many other legislative proposals in recent years, is extremely broad, and arguably overshoots its policy objectives. Numerous anomalies were brought to the attention of the Department of Finance prior to enactment of these rules. For various reasons, the Government proceeded to enact the SIFT legislation notwithstanding the many obvious anomalies.
The changes in the December 20, 2007 announcement are discussed below.
One of the key requirements for a trust or partnership to be a SIFT is that "investments" in the trust or partnership must be listed or traded on a stock exchange or other public market.
The definition of "investments" is very broad, and might arguably include an indirect entitlement of the investor to receive capital, revenue or income of a lower tier entity whose securities are not themselves listed. Thus, for example, a concern has been raised that an "in-house" partnership wholly-owned by a public company, or a lower tier trust in a typical "trust-on-trust" structure might itself be a SIFT, and therefore subject to entity level tax.
It is now proposed that the SIFT definition be amended to exclude trusts and partnerships whose equity and "equity-like debt" is (1) not publicly traded, and (2) wholly-owned by a SIFT, a qualifying REIT, taxable Canadian corporation, another entity meeting this test, or any combination of these types of entities. For this purpose, "equity-like debt" will include convertible debt and debt that pays participating interest as provided in recent amendments to the Canadian withholding tax rules.
While this change would seem to address many in-house arrangements, it highlights the concern that the SIFT rules could apply where, for example, equity interests in a privately-owned partnership are held by a combination of Canadian public corporations and tax exempts or individuals. For example, if an individual had transferred assets to a lower tier partnership of an income fund in exchange for partnership units that are exchangeable for units of the income fund (a not uncommon transaction), the proposed change will not apply.
Publicly-Traded Commercial Debts
Under the existing SIFT definition, a privately-owned trust or partnership that has issued publicly traded debt could be a SIFT. The Department of Finance is now proposing to amend the public trading test to exclude publicly traded debts as long as:
- at least 90% of the fair market value of the debts is held by entities that are not affiliated with the issuer; and
- none of the debts is equity-like debt (described above).
Portfolio Investment Entities
One element of the existing definition of a SIFT is that the relevant trust or partnership must hold one or more "non-portfolio properties" to be a SIFT. As currently drafted, a non-portfolio property includes securities of a wholly-owned subsidiary corporation or trust even if that entity only makes portfolio investments. The Department of Finance now intends to amend the definition of non-portfolio property to exclude securities of a "portfolio investment entity" which will be defined to mean an intermediate entity that holds no non-portfolio properties. This will, for example, facilitate the use of a holding trust by an investment trust as long as the holding trust itself does not hold non-portfolio properties.
Definition Of Canadian Real, Immovable Or Resource
As noted above, one element of the SIFT definition is that the relevant trust or partnership must hold at least one non-portfolio property. Non-portfolio property is defined to include shares of a corporation and interests in a trust or partnership if more than 50% of their fair market value is derived from real or immovable property in Canada or Canadian resource property. This creates an anomalous issue for a closed-end investment trust that happens to invest in Canadian real estate or resource companies. The Department of Finance now indicates that it will amend the definition of Canadian real, immovable or resource property to exclude shares of taxable Canadian corporations and interest in SIFTs.
Unfortunately, this exclusion was not extended to interests in a REIT. Accordingly, a closed-end investment trust could be a SIFT even if its investments are restricted to interests in REITs that themselves qualify for the exclusion from the definition of a SIFT.
Real Or Immovable Property Of REITs
The SIFT legislation defines certain REITs that qualify for exclusion from the definition of a SIFT. Unfortunately, the original definition of an excluded REIT was so narrow that it did not cover a large number of existing Canadian REITs. One element of the definition of a REIT is a 75% test that relates to Canadian real estate. In particular, the fair market value of the trust's real property situated in Canada (together with cash and government debt) must be at least 75% of the equity value of the trust. There is a similar 75% test with respect to the trust's revenues. To the extent this test limits a REIT's ability to own non-Canadian real property, its policy rationale is unclear. The Department of Finance has now announced that it will eliminate the distinction between Canadian and foreign properties for purposes of this test. Accordingly, a REIT with significant non-Canadian real property will not automatically be disqualified from qualifying as a REIT for this purpose.
Rent From A Subsidiary Trust
To qualify as a REIT for purposes of the exclusion from the SIFT definition, a trust must derive at least 95% of its revenues from rent from real properties or certain other sources. As is well known, many Canadian REITs use a tiered "trust-on-trust" structure. Under this structure, rental revenues may be earned by the lower tier trust and then distributed to the REIT itself. While there may have been persuasive arguments supporting the view that such revenue is "derived" from rent despite the fact that it is earned by the REIT through a lower level trust, it is understood that Canada Revenue Agency has not been prepared to accept such a position. The Department of Finance has now announced that the REIT rules will be amended to "clarify" that revenue from real property will not lose its character simply because it is paid through an intermediate trust.
Short-Term Investments Of REITs
The existing REIT definition requires that the total fair market value of Canadian real property, cash and government debt must be at least 75% of the equity value of the trust. The reference to cash and government debt was intended to enable a REIT to make short-term investments of liquid assets. The Department of Finance has now announced that it will expand the definition of such short-term investments to include amounts on deposit with a financial institution and bankers' acceptances. Finance also indicated that other kinds of liquid investments might be considered, but no specifics are provided in this regard.
REIT-Owned Nominee Corporations
One element of the existing REIT definition is that the trust must at no time hold any non-portfolio property, other than "qualified REIT properties". Qualified REIT properties for this purpose was defined so narrowly that it did not include shares of a nominee company if the nominee company held title to the real property for the benefit of a subsidiary of the REIT rather than the REIT itself. The Department of Finance has now announced that it will correct this anomaly. The definition of "qualified REIT property" will be amended to include shares of a nominee corporation that holds legal title to real property that is beneficially by either the REIT or a subsidiary of the REIT.
The December 20, 2007 announcement did not include detailed draft legislation. Finance stated that legislation to implement these proposed changes will be brought forward "at the earliest opportunity in 2008". Finance also stated that the amendments will apply on the same timetable as the existing SIFT taxation rules.
In the press release that accompanied the December 20, 1977 announcement, the Minister of Finance also indicated that the Government remained committed to working with affected taxpayers to ensure that existing SIFTs can convert to taxable Canadian corporations without undue tax consequences to the SIFT or its investors.
While the December 20, 2007 announcement is in some respects welcome, there is a significant number of other unresolved issues that have previously been brought to the attention of the Department of Finance. Examples of such unresolved issues include (but are not limited to) the following:
- Non-portfolio property includes property used in the course of carrying on a business in Canada. There is a lingering concern that a "business" for this purpose could include the business of investing in certain circumstances. Arguably, investments held in connection with such a "business" were never intended to be non-portfolio property. However, there remains some uncertainty on this point.
- To determine whether securities owned by a trust constitute non-portfolio property, the definition requires a determination as to whether fair market value of those securities is greater than 10% of the equity value of the trust or partnership. It is rather obvious that this requires a comparison of "apples and oranges" – since the equity value of the entity will be net of debt. In the case of a thinly capitalized trust or partnership, a relatively small investment might come within the definition of non-portfolio property merely because the equity value is minimal.
- The REIT safe harbour has not been extended to royalty trusts.
It is to be hoped that the December 20, 2007 announcement will be followed by further announcements of corrective measures regarding the scope of the SIFT rules.
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.