By Corrado Cardarelli, Andrew Wong and Grace Pereira
On October 24, 2012, Canada’s Department of Finance (Finance) introduced an omnibus technical bill (of some 1,000 pages) in a Notice of Ways and Means Motion (the Notice). The Notice proposes certain revisions to, among others, the rules in the Income Tax Act (Canada) (Tax Act) dealing with real estate investment trusts (REIT). This bulletin provides a summary of certain important aspects of those proposals in the Notice.
Certain proposals in the Notice were generally identical to, and were simply a reintroduction of, the corresponding provisions originally introduced on December 16, 2010 (the 2010 Proposals), which had not been enacted:
- Under the existing provisions of the Tax Act, a REIT for a taxation year could not own any "non-portfolio properties" (NPP) other than "qualified REIT properties" (QRP) at any time in the year. The Notice proposes to relax this requirement so that in general terms, a REIT may hold, on a fair market value basis, up to 10% of its NPPs that are not QRPs.
- Under the existing provisions of the Tax Act, a REIT must have at least 95% of its revenues from certain qualifying sources (such as rent, capital gains from disposition of real property, dividends, interest, royalties). This requirement has been relaxed so that the 95% threshold will be reduced to 90%.
- Under the existing provisions of the Tax Act, a REIT must satisfy two "revenue" tests: (i) the 95% revenue test referred to in point 2 above and (ii) a second test requiring at least 75% of a REIT’s revenues to be from more limited qualifying sources – rent, capital gains from disposition of real property and interest from mortgages. The proposals introduced the defined term "gross REIT revenue" to clarify the concept of revenue in the context of REITs. In general, gross REIT revenue of an entity for a taxation year refers to the amount, if any, by which the total of all amounts received or receivable exceeds the total of all amounts, each of which is the cost to the entity of a property disposed of in the year.
- Under the existing provisions of the Tax Act, the REIT exception did not explicitly require QRP to be capital property of the REIT. This has now been addressed in the 2010 Proposals and the Notice. In this connection, a new defined term, "eligible resale property," has been introduced to permit a REIT to hold non-capital property in only limited circumstances. An "eligible resale property" of a REIT must generally be "contiguous" to a particular real property that is capital property or another eligible resale property. In addition, the holding of the eligible resale property must be "ancillary" to the holding of the particular real property.
The policy behind the concept of eligible resale property is that a REIT would be permitted to hold in limited circumstances certain development properties or other properties that may not be capital in nature.
As a result of submissions made to Finance in response to the 2010 Proposals, the Notice also revised certain aspects of or introduced certain rules that were not included in, the 2010 Proposals:
- As noted above, "real or immovable property" would qualify as a QRP as currently defined in the Tax Act irrespective of whether it is a capital property. The 2010 Proposals narrowed the definition so that only real or immovable property that is capital property would qualify as a QRP. The Notice expands the definition of a QRP, which will include real or immovable property that is either a capital property or an eligible resale property. The Notice includes "eligible resale property" as a “good asset” that a REIT may own for purposes of the 75% asset test.
- The existing definition of QRP in the Tax Act also includes, in general terms, property ancillary to the earning of rent. The 2010 Proposals would have limited such ancillary property to, in general terms, tangible personal property. The Notice removes the tangible personal property requirement, but instead carves out an "equity" of an "entity" as well as a mortgage, hypothecary, claim, mezzanine loan or similar obligation. Thus, a mezzanine loan, for instance, would count toward the 10% allowance for NPPs that are not QRPs as noted in point 1 above.
- Under the existing provisions in the Tax Act, a trust that, for instance, holds its non-Canadian real or immovable properties through a subsidiary may not qualify as a REIT since dividends from the subsidiary would not be considered to be qualifying "gross REIT revenue" for the 75% revenue test referred to in point 3 above.
The 2010 Proposals provided for seemingly broader character preservation rules that would apply where a parent entity holds a security in a subsidiary which is NPP for the parent and an amount is included in computing the parent entity’s gross REIT revenue for a taxation year in respect of an amount that has become payable by the subsidiary entity to the parent entity with respect to this security. Such character preservation rules would have generally treated distributions from the subsidiary entity to the parent entity as gross REIT revenue of the parent entity to the extent that such distributions could reasonably be considered to have become payable out of the subsidiary’s gross REIT revenue from a particular source, and such gross REIT revenue of the parent would be deemed to be from that source. There were two problems with the 2010 Proposals: (i) the Explanatory Notes to the 2010 Proposals referred to only "trust on trust" structures (but not to “trust on corporation” structures) and (ii) in the case where a trust holds its foreign real property through a foreign subsidiary corporation, the securities of such corporation would not have qualified as NPP if the corporation’s principal source of income is not one or any combination of sources in Canada.
In the Notice, Finance addressed the two concerns with respect to the 2010 Proposals. The rules in the Notice refer to a “specified amount” received from a "parent entity" from a "source entity." The parent entity must be either "affiliated" with the source entity or must hold "securities" (in this case equity interests only in corporations, trusts or partnerships) of the source entity that have a fair market value greater than 10% of the equity value of the source entity. In addition, the "specified amount" must be included in the parent entity’s gross REIT revenue in respect of a security (debt or equity) of the source entity held by the parent entity. If those requirements are met (subject to a special rule where the source entity is involved in maintaining, improving, leasing or managing of the REIT’s real properties), the characterization preservation rule applies for the purposes of the "REIT" definition tests. In particular, to the extent that the specified amount can reasonably be considered to be derived from gross REIT revenue of the source entity having a particular character, the specified amount in the hands of the parent entity is deemed to be gross REIT revenue of the parent entity having that same character and not any other character. The changes proposed by the Notice will be extremely useful in many contexts but especially in the case of cross-border REITs. In a typical structure, the cross-border REIT normally has a debt interest in a U.S. corporation (USCo) that, in turn, has a partnership interest in a U.S. partnership that owns U.S. real properties. These rules should have the effect of treating the interest income from USCo treated as gross REIT revenue of the REIT having the same character and not having any other character (for purposes of the REIT definition tests). Similar considerations would apply with respect to dividends the REIT receives from shares of a Canadian corporation that owns shares of that USCo.
- Under the existing provisions of the Tax Act, a REIT with foreign properties may not qualify as a REIT if it realizes significant foreign exchange gains. Such foreign exchange gains would not be treated as qualifying revenue for purposes of the REIT definition tests.
The 2010 Proposals would have permitted such a REIT to treat, as qualifying REIT revenue, foreign exchange gains in respect of rent and debt incurred for certain purposes where such gains resulted from hedging the foreign currency of a country in which the REIT holds a real or immovable property and are included in the REIT’s gross REIT revenue.
The proposed changes in the Notice expand on the 2010 Proposals by extending the favourable treatment to amounts resulting from an agreement that hedges interest rates in respect of debt incurred by the REIT to acquire or refinance real or immovable property (where such amounts are included in the REIT’s gross REIT revenue). Thus, amounts in respect of such interest rate hedges or foreign currency hedges may now be treated as having the same character as gross REIT revenue from the underlying properties.
The proposals introduced by the Notice, if enacted as proposed, would generally be effective to a REIT for the 2011 and subsequent taxation years or, if elected in writing by the REIT, for earlier taxation years.
To discuss these issues, please contact the authors.
This bulletin is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this bulletin with you, in the context of your particular circumstances.
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