Commentary on October 24, 2012 Notice of Ways and Means Motion Relating to Tax Matters - Real Estate Investment Trusts
Nov 1, 2012
In a Notice of Ways and Means Motion tabled by the Minister of Finance on October 24, 2012 (the “NWMM”), there were a number of changes to the provisions of subsection 122.1 of the Income Tax Act (Canada) (the “Act”) dealing with real estate investment trusts (“REITs”) as compared to the prior version of those provisions which was included in draft legislation released by the Minister of Finance on December 16, 2010 (the “December 16 Proposals”). In general, such changes are either relieving in nature or fix certain technical anomalies that were included in the December 16 Proposals.
A trust that qualifies as a REIT is not subject to the provisions of the Act relating to specified investment flow-through trusts (“SIFTs”). As a result, a REIT will generally not be subject to taxation under the Act provided it pays, or makes payable, distributions to its unitholders in a taxation year that are not less than the income of the REIT for that taxation year.
To qualify as a REIT for a particular taxation year, a trust must meet all the requirements under a five-part test, which is comprised of a non-portfolio property test, two revenue tests, an asset test and a publicly traded test, which may be generally described as follows:
- The Non-Portfolio Property Test: at all times during the taxation year, the fair market value of the “qualified REIT properties” of the trust must be at least 90% of the fair market value of all the non-portfolio properties of the trust;
- The 90% Revenue Test: Not less than 90% of the gross REIT revenues of the trust for the taxation year must be from rent from real or immovable properties, interest, dividends, royalties and dispositions of capital properties and eligible resale properties;
- The 75% Revenue Test: Not less than 75% of the gross REIT revenues of the trust for the taxation year must be from rent from real or immovable properties, interest from mortgages, or hypothecs, on real or immovable properties and capital gains from dispositions of real or immovable properties;
- The Asset Test: at each time during the taxation year, the total fair market value of properties of the trust that are real or immovable properties that are capital properties or eligible resale properties or, in general terms, cash or cash-like investments must be an amount that is equal to 75% or more of the equity value of the trust at that time; and
- The Publicly Traded Test: investments in the trust are, at any time in the year, listed or traded on a stock exchange or other public market.
Eligible Resale Properties
A number of the changes in the NWMM, as compared to the December 16 Proposals, are related to eligible resale properties which are, in general terms, real properties generally held by subsidiaries of a trust that are not capital properties (because, for example, it is anticipated that they will be severed and sold), but that are contiguous and ancillary to capital properties held by those subsidiaries or their affiliates. In particular, the definition “eligible resale property” has been changed in the following ways:
- In the December 16 Proposals, an eligible resale property could be held only by an entity in which a publicly-traded trust held a security (i.e., by a direct subsidiary of a REIT). Under the NWMM, this requirement has been deleted. As a result, eligible resale properties may now be held by either direct or indirect subsidiaries of a REIT.
- In the December 16 Proposals, an eligible resale property could be contiguous only to capital property. Under the NWMM, an eligible resale property may now be contiguous to either capital property or to a property that is itself an eligible resale property.
- In the December 16 Proposals, the contiguous property could be held only by the entity that owned the eligible resale property or by another entity in which the REIT held a security (i.e., a direct subsidiary of the REIT). Under the NWMM, the contiguous property may now be held by the entity that owns the eligible resale property or by any other entity that is affiliated with such entity.
- The December 16 Proposals required that an eligible resale property be “necessary and incidental” to the contiguous property. Under the NWMM, the eligible resale property need only be “ancillary” to the contiguous property.
There are also several changes that have been made under the NWMM to ensure that the ownership of eligible resale properties by entities within a REIT structure does not affect the ability of those entities to qualify as REITs. In particular, eligible resale properties will now be “qualified REIT properties” with the result that a REIT will not have to include eligible resale properties in its 10% basket of permitted non-portfolio properties. In addition, for taxation years beginning after 2012, eligible resale properties will be ‘good’ assets for purposes of the 75% asset test in paragraph (d) of the definition “real estate investment trust.”
Qualified REIT Property
As noted above, in order for a trust to qualify as a REIT, at all times during the taxation year, the fair market value of the “qualified REIT properties” of the trust must be at least 90% of the fair market value of all the non-portfolio properties of the trust. The definition “qualified REIT property” has been expanded in the NWMM to include all of the assets listed in paragraph (d) of the definition “real estate investment trust”, including cash and cash-like investments and eligible resale properties. As a result, a trust will no longer need to rely on its 10% non-portfolio property basket or the ancillary test (discussed further below) with respect to the ownership of such properties.
Another important change in the NWMM relates to the type of property that will qualify under paragraph (d) of the definition “qualified REIT property” as property that is “ancillary” to the earning by the trust of rent and capital gains from the disposition of real property. In the December 16 Proposals, property could only qualify as ancillary under this paragraph if it was tangible personal property. This raised issues as to whether a REIT could own other types of property that were ancillary to the earning of rent and capital gains such as cash, contractual rights or receivables.
In the NWMM, paragraph (d) of the definition “qualified REIT property” includes any property that is ancillary to the earning by the trust of rent or capital gains from the disposition of real property, other than an equity of an entity or a mortgage, hypothecary claim, mezzanine loan or a similar obligation. In the Explanatory Notes to the NWMM, the Department of Finance specifically notes that unpaid rent will not be considered to be a similar obligation.
Gross REIT Revenues
As noted above, the concept of “gross REIT revenues” is relevant to the two revenue tests that must be met in order for a trust to qualify as a REIT. The definition “gross REIT revenues” has been simplified in the NWMM such that gross REIT revenues are now simply the excess of all of the amounts received or receivable by the REIT in a year over the cost of any property disposed of by the REIT in the year. This change resolves the technical anomaly in the December 16 Proposals which resulted in the entire amount of the proceeds from a disposition of an eligible resale property being included in gross REIT revenues but only the gain from such a disposition being included as ‘good’ revenue for purposes of the 90% revenue test in paragraph (b) of the definition “real estate investment trust”.
Revenue Character Flow-Through and Hedging Rules
The provisions relating to the flow-through of the character of revenue from lower-tier entities (referred to in the NWMM and below as “source entities”) to upper-tier entities (referred to in the NWMM and below as “parent entities”) within a REIT structure have been changed under the NWMM in a number of ways. In particular, the NWMM has clarified the following:
- the revenue characterization rules apply to amounts “received or receivable” by a parent entity from a source entity;
- the revenue characterization rules apply where the amounts that were received or receivable by the parent entity were in respect of a security of the source entity that is a share of a corporation, an income or capital interest in a trust or an interest in a partnership;
- the parent entity and the source entity must be affiliated or the parent entity must hold securities of the source entity that have a total fair market value that is greater than 10% of the equity value of the source entity;
- the securities of the source entity do not need to be non-portfolio property (which was a requirement in the December 16 Proposals), with the result that the revenue characterization rules will apply to the revenues of foreign entities within a REIT structure;
- the “character” (rather than the “source” as was the case in the December 16 Proposals) of an item of revenue in the hands of the source entity will be retained in the hands of the parent where the revenue characterization rules apply; and
- the revenue characterization rules will not apply in respect of amounts received or receivable by a parent entity from a source entity that is described in paragraph (b) of the definition “qualified REIT property” (i.e., a management subsidiary) to the extent such amounts are derived from maintaining, improving, leasing or managing real or immovable properties that are capital properties of the parent entity or of an entity in which the parent entity holds a share or an interest, including co-owned properties.
The provision relating to hedging transactions entered into by a REIT or its subsidiaries has also been clarified and expanded under the NWMM. In particular:
- The hedging provision has been expanded to apply to interest rate hedges and to foreign currency hedges in respect of the revenues from a real or immovable property; and
- If the hedging provision applies, it will deem revenues from the relevant hedging agreement to have the same character as gross REIT revenue in respect of the real or immovable property to which the hedging agreement relates.
The above-described changes significantly improve the drafting of the REIT rules by resolving a number of the technical anomalies that were present in the December 16 Proposals, thereby resulting in what will hopefully be a workable regime for REITs and their investors.
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