On December 16, 2010, the Department of Finance proposed amendments to the rules governing real estate investment trusts (REITs). The proposed changes would generally make it easier for trusts to qualify as REITs and will be effective as of January 1, 2011.
The proposed amendments include:
- character of income flow-through for certain distributions made from subsidiary entities
- allowance for certain foreign exchange gains in connection with investments in foreign real estate
- reducing asset and revenue thresholds — a REIT will be permitted to own 10 per cent "bad" assets by value; 95 per cent revenue test reduced to 90 per cent
- permissible "ancillary" property limited to tangible personal property and corporeal moveable property
- clarification of rules surrounding inventory real estate; gains from sale of inventory real estate "good" revenue (for 95 per cent test)
- requirement that securities of a trust be publicly traded for trust to qualify as a REIT
An exception to the SIFT tax (which is generally imposed beginning in 2011) is available for a REIT. To qualify for the REIT exception a trust must satisfy two revenue-related tests and two asset-related tests.
A REIT must derive at least 95 per cent of its revenues from a specified list of passive types of revenues; and (b) at least 75 per cent of its revenues from a specified list of passive types of real estate related revenues (e.g., rents from real estate, mortgage interest, etc.).
The asset tests are more complicated. First, a REIT cannot own any "non-portfolio property" (NPP), unless such NPP was "qualified REIT property" (QRP). NPP includes securities in a subsidiary entity if two conditions are satisfied: (1) the trust either owns more than 10 per cent of the shares or units of the entity, or the shares or units that the trust owns represents more than 50 per cent of the trusts assets; and (2) the subsidiary entity is not a "portfolio investment entity" (PIE), which in turn is generally an entity that owns no NPP. NPP also generally includes real estate situated in Canada if at any time in a taxation year the value of such real estate is greater than 50 per cent of the value of the trust's equity. Finally, NPP also includes property used by the trust or a related person in the course of carrying on a business.
The second asset test requires that at all times in a taxation year the REIT own real estate and certain cash-equivalents with a value of at least 75 per cent of the REIT’s equity value.
The proposed amendments are intended to address deficiencies in the existing REIT rules.
II. PROPOSED AMENDMENTS
A. Lowering Revenue & Asset Thresholds
A frequent criticism of the REIT rules is that they are difficult to comply with in practice and do not contain a remedial process for minor violations. Although the proposed amendments do not introduce any ability to remediate, they will reduce the thresholds of two of the tests.
The prohibition on holding NPP that is not QRP — what is likely the most difficult rule to satisfy in practice — will be changed to permit a REIT to hold NPP that is not QRP as long as the value of such NPP is less than 10 per cent of the value of all NPP held by the REIT. Additionally, the 95 per cent revenue test will be reduced to a 90 per cent test.
These amendments should better conform the rules to practical reality and meaningfully reduce the compliance risk for REITs.
B. "Revenue" defined
For purposes of the "revenue" threshold tests, the proposed amendments will modify the relevant tests to be based on "gross REIT revenue", which will include (a) amounts received or receivable in the taxation year (depending on method of tax income accounting) otherwise than on account of capital; and (b) capital gains realized in the taxation year. This change is intended to clarify that revenues do not include proceeds of disposition other than capital gains, and in particular to exclude recapture of depreciation.
Unfortunately the proposed definition of gross REIT revenue does not go further in defining amounts received or receivable in different fact scenarios. Canada Revenue Agency (CRA) has attempted to resolve certain interpretive questions administratively and others likely remain.
C. Limited Inventory Holdings Permitted
The proposed amendments will restrict REITs from holding inventory real estate, unless held in a subsidiary in limited circumstances.
"Eligible resale property" will be real or immovable property (that is not capital property) owned by a subsidiary of a REIT and (a) that is contiguous to real estate held as a capital property of the owner or another entity in which the REIT holds a security; and (b) the holding of which is necessary and incidental to the holding of the particular real estate. Consequential to this change, the 90 per cent revenue test will be expanded to include gains from dispositions of eligible resale properties.
The explanatory notes to the proposed amendments provides the example of a commercial development of a REIT that is to be severed for the ownership and use of an anchor tenant where the holding of such property is necessary and incidental to the holding of the commercial development.
D. Character of income flow-through from certain subsidiary entities
The proposed amendments will resolve an anomaly that existed regarding the choice of entity through which a REIT indirectly holds real estate. For purposes of the QRP asset test, securities of an entity are QPR for the asset test if the issuer of the securities, regardless of its form of business association, would satisfy the two revenue tests and the two asset tests.
However, for purposes of the revenue tests there is no general flow-through of the character of revenues (with the exception of partnerships). Distributions from a corporate subsidiary would be dividend revenue, and more problematically, distributions from a trust would generally be trust distributions. Accordingly, there is a risk that while a REIT satisfied the asset tests, revenue distributed by subsidiary entities could cause the REIT to fail the revenue tests. Responding to pressure from the tax community, in 2008 a limited character flow-through rule was enacted for trust distributions derived from rent from real or immovable property, however other types of revenues (that may be good revenues for purposes of the revenue tests) did not benefit from character flow-through.
The proposed amendment will provide a form of character flow-through for distributions on securities, provided the securities would be NPP to the holder (i.e., the holder either owns 10 per cent or more of the distributing entity or the securities represents 50 per cent or more of the value of the holder's assets). This will include a debt security, thus this rule appears to extend to interest payments made by a subsidiary entity if the cash flow funding the interest could reasonably be considered to have come from another good source of revenues (e.g., interest payments funded with rent receipts).
E. Currency fluctuations
Under the REIT rules there is no requirement that trust exclusively own real estate located in Canada. The proposed amendments will deem certain foreign exchange gain or foreign exchange hedging gain to be of the same character as the underlying foreign currency transaction or transaction being hedged.
For example, an embedded foreign exchange gain arising on the disposition of foreign real estate would be deemed to be gain from the disposition of real or immovable property for purposes of the revenue tests. Similarly, a foreign exchange gain on foreign denominated debt incurred to acquire the foreign real estate would be characterized as gain from the disposition of real or immovable property.
Foreign currency hedging transactions, such as staggered forward sales of foreign currency corresponding to rent payment dates would similarly be deemed to be characterized as rent from real or immovable property (i.e., the particular source of revenue that is being hedged).
Interestingly there is no proposed amendment with respect to domestic hedging transactions, e.g., interest rate hedges or interest rate locks in anticipation of financing. Revenue arising from such contracts are not enumerated in the revenue tests, but there is no policy reason for treating such revenues as "bad" revenues. Additionally, the Canadian characterization of basic derivative contracts raises interesting questions as to the asset characterization of a derivative contract.
F. Ancillary property limited to tangible personal and corporeal moveable property
The definition of QRP included property that was "ancillary" to the earning of rents or capital gains from real or immovable property. The technical notes to the original legislation contained the examples of office furniture and computer equipment. The proposed amendments will expressly restrict the types of property that could qualify as "ancillary" to tangible personal property or corporeal moveable property in Québec.
Real or immovable property is itself QRP, therefore this amendment would seem to only operate to exclude intangible business assets from the ambit of the what could potentially be "ancillary" for these purposes.
G. Public listing requirement
The proposed amendments will also expressly require that "investments" (defined broadly to include both debt and equity securities) in a trust be listed or traded on a stock exchange or other public market during the taxation year in order for the trust to qualify as a REIT. This amendment is consistent with the SIFT rules generally, under which a trust is only a SIFT trust if (among other things) investments in it are publicly traded.