On December 16, 2010, the Department of Finance Canada (Finance) released for public consultation draft legislative proposals (the Draft Legislation) to amend the real estate investment trust (REIT) rules in the Income Tax Act (Canada) (the Act), as well as related explanatory notes (the Explanatory Notes). The Draft Legislation is intended to apply generally to the 2011 and subsequent taxation years, except that a trust may elect to have the amended rules apply to taxations years that end after 2006 and before 2011 if investments in the trust were listed or traded on a stock exchange or other public market in one or more of those taxation years. Finance has invited interested parties to provide comments on the Draft Legislation by January 31, 2011.
The general effect of the Draft Legislation is to relax some aspects of the restrictive conditions that REITs must satisfy to be exempted from the specified investment flow through trust (SIFT) tax which took effect for grandfathered SIFTs on January 1, 2011. Compliance with the highly technical conditions set out in subsection 122.1 of the Act has been a significant concern for grandfathered REITs since the SIFT rules were introduced in 2006. Virtually all of the 30 or so REITs in existence when the rules were first introduced concluded that they could not comply fully with the conditions for REIT status. Thus began a series of lobbying efforts and submissions to Finance attempting to explain how the REIT industry actually functions and soliciting Finance’s assistance in crafting legislation that accommodates current REIT business structures. The Draft Legislation represents the fourth (but probably not the final) round of legislative amendments relating to the REIT definition.
SUMMARY OF SIGNIFICANT PROPOSED CHANGES TO THE REIT EXEMPTION
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This bulletin will first review the current rules and then discuss the changes proposed by the Draft Legislation.
CURRENT RULES: QUALIFYING REIT
In order to qualify as a REIT for a taxation year under subsection 122.1(1) of the Act (and therefore qualify for exemption from the SIFT rules), a trust must be resident in Canada and satisfy all of the following four conditions throughout the year:
- NPP Test: the trust must not hold any ‘‘non-portfolio property’’ (NPP)1 other than “qualified REIT properties” (QRP). Under the current rules, this is an all-ornothing test, i.e., if the trust holds any NPP that is not QRP, even for an instant, it will fail this test.
- Property Revenue Test: at least 95% of the trust’s revenues for the taxation year must be derived from one or more of the following: (1) “rent from real or immovable properties”; (2) interest; (3) capital gains from dispositions of real or immovable properties; (4) dividends; and (5) royalties.
- Real Property Revenue Test: at least 75% of the trust’s revenues for the taxation year must be derived from one or more of the following: (1) rent from real or immovable properties; (2) interest from mortgages or hypothecs on real or immovable properties; and (3) capital gains from dispositions of real or immovable properties.
- Equity Value Test: the total fair market value of real and immovable property, cash and certain cash equivalents held by the trust must equal or exceed 75% of the total fair market value of all of the income and capital interests in the trust at that time.
QRP of a trust is defined in subsection 122.1(1) to mean four types of property held by the trust:
- “real or immovable property”, which includes: (i) a security of an entity that satisfies the four REIT tests, and (ii) an interest in real property or a real right in immovables (other than certain resource royalty rights). Depreciable property is specifically excluded except for Class 1, 3 or 31 assets; (ii) property ancillary to the ownership or utilization of such property; and (iii) a lease in, or a leasehold interest in respect of, such property.
- a security of a “subject entity” – i.e., a Canadian resident corporation, trust or partnership, or a non-resident person or partnership the principal source of income of which is from one or more Canadian sources – that derives 90% or more of its revenues from maintaining, improving, leasing or managing capital real or immovable properties of the trust or one of its subsidiary entities;
- a security of a wholly-owned subsidiary of the trust or of a subject entity that holds only legal title to real or immovable property (or ancillary property as described below); and
- property that is “ancillary to” the trust’s earning of rent from real or immovable properties or capital gains from the dispositions of real or immovable properties.
“Rent from real or immovable properties” is defined in paragraph 122.1(1) to include:
- rent or similar payments for the use of, or right to use, real or immovable properties;
- payment for services ancillary to the rental of real or immovable properties and customarily supplied or rendered in connection with the rental of real or immovable property; and
- a payment made out of the trust’s current income that is derived from rent from real or immovable properties, to the extent that it is included in the payee’s income.
Explicitly excluded from qualifying as “rent from real or immovable properties” are payments for services supplied or rendered to the tenants of such properties (other than payment for ancillary services as described above), fees for managing or operating such properties, payments for the occupation of, use of, or right to use a room in a hotel or other similar lodging facility, and rent based on profits.
DRAFT LEGISLATION - PROPOSED CHANGES
1. REITs Can Hold Up to 10% of NPP as Non-QRP
One of the principal shortcomings of the REIT definition is the all-or-nothing approach to the type of property that may be owned by a REIT and its subsidiaries. Even a de minimis investment in non-QRP could disqualify a REIT, creating significant and unintended tax consequences for investors. The Draft Legislation proposes to amend the NPP Test to allow up to 10% of the fair market value of a REIT’s NPP not to be QRP. Introducing a safe harbour, similar to the approach adopted in both the U.S. and the U.K., is a very welcome change.
Relaxing the all-or-nothing test will be of significant practical benefit to many REITs, although it will not be enough to enable hotel and nursing home REITs to comply with the REIT exemption. That type of change would require a shift in the policy direction of Finance, rather than a clarification of the existing legislation. The obvious source of that policy change would be the U.S., which accommodates a REIT structure involving “taxable REIT subsidiaries” that carry on, for example, a hotel business using land owned by the REIT. By comparison, the Canadian policy continues to restrict publicly traded REITs to earning passive rental income.
2. Revenue Tests Based on Gross REIT Revenue
Under the Draft Legislation, “gross REIT revenue” will replace “revenue” for the purposes of determining whether a security of a subject entity qualifies as QRP, and whether the Property Revenue and Real Property Revenue Tests are met. An entity’s “gross REIT revenue” for a taxation year will be all amounts received or receivable by it in the year other than capital receipts, and all capital gains. Unfortunately, the exclusion of recapture under existing rules is continued under the concept of gross REIT revenue. Neither the Draft Legislation nor the Explanatory Notes address whether capital losses would reduce gross REIT revenue in determining whether the revenue tests are met.
3. REIT Subsidiaries May Hold Certain Eligible Resale Property
The Draft Legislation provides a limited opportunity for directly held REIT subsidiaries to hold noncapital real property that fits within the new definition of “eligible resale property”.2 The scope of these amendments is very narrow and does not in any way suggest a broader accommodation of development type activities being generally undertaken for the benefit of a REIT. The new concept of “eligible resale property” is restricted to non-capital real or immovable property of a subsidiary entity of a listed or traded trust (a) that is contiguous to a particular capital real or immovable property of the entity or of another subsidiary entity of the trust, and (b) the holding of which is necessary, and incidental, to the holding of the particular real or immovable property.
Under the Draft Legislation, gains from the disposition of eligible resale properties will be “good” gross REIT revenue for the Property Revenue Test, and a subject entity’s revenue from managing eligible resale properties will be “good” gross REIT revenue for determining whether a security of the subject entity qualifies as QRP.
The Explanatory Notes state that this amendment is intended to allow for the “temporary or occasional” holding by a REIT subsidiary of qualifying non-capital property. The example given is of a portion of a commercial development of a REIT that is to be severed for the ownership and use of an anchor tenant, where the REIT’s holding of the property is necessary and incidental to the holding of the commercial development. However, other than providing this example, Finance does not elaborate on what it would consider to be a temporary or occasional holding, and the proposed definition of “eligible resale property” contains no such restriction. On the question of whether a holding would be incidental to the holding of a particular real or immovable property, some guidance may be obtained from case law in other tax contexts, such as whether income is incidental to an active business for purposes of the small business deduction or the foreign affiliate rules.
4. Property Revenue Test Relaxed
The Draft Legislation’s proposed changes to the Property Revenue Test – reducing the 95% minimum threshold to 90%, basing the revenue test on gross REIT revenue, and expanding the list of permitted revenue sources to include gains from the disposition of eligible resale properties – will make it easier for REITs to satisfy this test.
5. Ancillary Property Restricted to Tangible Personal/Moveable Property
The Draft Legislation proposes to amend the QRP definition to restrict the types of property that can be “ancillary” to a trust’s earning of rent from real or immovable properties or capital gains from the dispositions of real or immovable properties to tangible personal property or corporeal moveable property under Quebec civil law.
Finance’s Backgrounder accompanying the Draft Legislation states that the proposed amendment clarifies the existing provision for ancillary property to “better describe the type of properties that can be considered ancillary”. It is questionable whether the proposed amendment is clarifying in nature since the concept of “ancillary property” was not defined in the Act. Further, Finance’s brief comments on the meaning of ancillary property and services in the Technical Notes to the REIT definition and the CRA’s published views have suggested a potentially broad approach to what constitutes ancillary property under the existing rules. Relying on that broad approach, some have suggested that intangible property such as a mortgage could be considered to be ancillary property in appropriate circumstances, such as if it were supportive of an investment in real estate by a REIT group. The proposed amendment will preclude that possibility, as it will exclude all intangible property, including equity and debt securities, from qualifying as ancillary property for purposes of the rules. Thus, the proposed relieving change allowing REITs to hold up to 10% of their NPP as non- QRP comes at the price of restricting the scope of ancillary property for purposes of the REIT exemption.
6. Character of Subsidiary Entity Revenue Flows Through For Revenue Tests
One of the most challenging aspects of earlier versions of the REIT definition was the failure to align the definition with the actual business practice of having a trust-on-trust-onpartnership structure (and possibly an underlying corporate subsidiary), together with a number of nominee corporate entities. Of particular concern was the potential “loss of character” where rental income passing through a trust could no longer be said to be “derived from” the underlying rental activities. The Draft Legislation proposes new rules which provide that a subsidiary trust’s revenues flowing through to its parent trust will retain their source characterization for the purposes of determining the source of revenues of the parent trust. This is a welcome and longawaited amendment accommodating trust-ontrust structures. It broadens the narrow flow-through rule introduced in 2008 which applied only to a subsidiary’s income derived from real or immovable properties. The new rule in the Draft Legislation will apply to all of a subsidiary trust’s gross REIT revenue from any source (e.g., rental income, mortgage interest or proceeds from the disposition of capital property).
7. Foreign Currency and Hedging Gains Linked to Qualifying REIT Revenue Source
The Draft Legislation proposes a new rule to permit a REIT to treat, as qualifying REIT revenue, certain foreign currency gains and foreign currency hedging gains realized in respect of, and debt incurred for the purpose of earning revenue from, qualifying sources of REIT revenue. For the purposes of determining whether an amount included in gross REIT revenue of a trust for a taxation year is from a particular foreign real or immovable property source, the following amounts are deemed to be from that source (and not from any other source):
An amount included in gross REIT revenue of the trust for the taxation year that is a gain from that source from fluctuations in the value of the foreign currency relative to Canadian currency, or debt incurred by the trust for the purposes of earning revenue from that source; and
An amount included in gross REIT revenue of the trust for the taxation year that results from an agreement that provides for the purchase, sale or exchange of currency, and can reasonably be considered to have been made by the trust to reduce its risk in fluctuations in the value of the currency of that country relative to Canadian currency.
Since the proposed amendment addresses only foreign currency hedging gains, it remains an open issue whether interest rate hedging gains may be included in gross REIT revenue for purposes of the revenue tests.
8. Fifth REIT Condition Added
Under the Draft Legislation, in order to qualify as a REIT, investments in a trust would have to be listed or traded on a stock exchange or other public market throughout the relevant taxation year. The Explanatory Notes indicate that this addition is consequential to the amendment to the definition of “Canadian real, immovable or resource property” described below.
9. REIT Investments Not Canadian Real, Immovable or Resource Property (CRIRP)
Closed-end funds which held portfolio investments in SIFT type entities could be potentially swept up in the SIFT rules if the fair market value of their portfolio investments that constitute CRIRP (as defined in subsection 248(1) of the Act) were greater than 50% of their equity value at any time in a taxation year. For the purposes of determining whether property of a trust is NPP under the NPP Test, it is proposed that the definition of CRIRP will be amended to exclude investments in a REIT, provided that units of the REIT are listed throughout the taxation year. Consequently, a closed-end fund will be able to invest in REITs and whatever is left of the income trust market without those investments potentially causing the fund to be subject to the SIFT rules.
Comment and Future Developments
The Draft Legislation appears to respond to some of the REIT industry’s main concerns by relaxing, and clarifying some aspects of, the conditions necessary to qualify for the REIT exemption from the application of the SIFT rules. However, as the preceding discussion indicates, the Draft Legislation raises some questions which it is hoped that Finance will clarify in the next draft of the proposed amendments. It also does not address some of the continuing concerns raised by the REIT industry such as the lack of curative provisions, the treatment of non-ancillary parking areas, and the impact on REIT status of mortgages held by a REIT. While mortgage investment funds are unlikely to pass the NPP test to qualify for the REIT exemption due to the nature of their investments, they may be structured as private mutual fund trusts or perhaps as mutual fund corporations such that they are not subject to the SIFT rules.