Affirmation of Proposal to Tax SIFTs

On March 27, 2007 the Department of Finance released draft legislation largely confirming its previous proposal (first released on October 31, 2006) to impose a tax on income funds and other specified investment flow-through trusts ("SIFTs").  The tax is intended to approximate a corporate rate of tax, with the taxed income treated as corporate dividends when distributed to unitholders. Most existing publicly-traded trusts will be exempt from the tax until 2011.  However, the March 27, 2007 draft legislation provides that SIFT trusts will become subject to the new tax on the first day after December 15, 2006 on which they exceed normal growth guidelines that were issued by the Department of Finance on December 15, 2006.  New trusts will be subject to the new tax immediately.

No concessions are made in the March 27, 2007 draft legislation to exempt oil and gas or other energy income funds from the tax after 2010.

REIT Safe Harbour

A trust that qualifies under the draft legislation as a "real estate investment trust" or "REIT" will be exempt from the proposed tax.  The definition of a qualifying REIT contains significant departures from the definition in the previous (December 21, 2006) version of the draft legislation. 

Stringency of the REIT Tests

The tests for qualifying as a REIT for tax purposes (which are summarized below under "Summary of Tests") are by far the most stringent of the major English-speaking jurisdictions (the U.S., the U.K. and Australia).  Many or most Canadian REITs will encounter substantial difficulties in meeting these tests in which case they will need to engage in significant restructuring.  Some problem areas are listed below.

1.  Trust-on-Trust REITs:  Offside

Most REITs that have been formed since 2002 have utilized a "trust on trust" structure under which the REIT itself does not hold real estate, but instead holds a subsidiary trust that, in turn, holds an operating subsidiary partnerships or corporations that are the owners and operators of the real estate.  Such REITs will not qualify as REITs under the draft legislation because they do not directly earn rents from Canadian real property, interest from mortgages on Canadian real property or other qualified revenue.

2.  Management Subsidiaries:  Will often put REIT offside

Many REITs have management subsidiaries that manage real estate owned by the REIT or by REIT subsidiaries, or manage real estate held in joint ventures with third parties.  A permitted management subsidiary in the draft legislation must derive all or substantially all of its revenues directly from managing real properties that are capital properties of the trust.  This test is very narrow.  Revenue for purposes of this test does not include, among other things, management fees earned by the management subsidiary from managing real estate of a "sister" subsidiary, management revenue earned from third parties (although management revenue from managing a REIT's co-ownership interest in jointly held properties is good revenue) and fees for managing real estate held for development purposes.

3.  Development Subsidiaries:  Will generally put REIT offside

Subsidiaries that hold real estate for development purposes (including development for sale to the REIT), so that such real estate constitutes inventory rather than capital property, will not realize capital gains from the disposition of that property.  This result may be de minimus or quite incidental to major capital property investments.  However, where it occurs it appears likely that the subsidiaries cannot safely be treated as qualifying subsidiaries, in which case the REIT will not be a qualifying REIT.

4.  Seniors' Residences REITs: Offside

Due to existing requirements in the income tax legislation, such REITs are required to carry on their operations through subsidiaries rather than directly.  The intent of the draft legislation appears to be that such subsidiaries will not be qualifying subsidiaries.

5.  Hotel REITs: Offside

These REITs are structured in the same manner as seniors' residences REITs.  The draft legislation (particularly the exclusion of a "payment for the occupation of, use of, or right to use a room in a hotel or other similar lodging facility" from the definition of rent) means that the operations of hotel REITs will prevent them from qualifying as REITs.

6.  Mortgages Owing by Special Purpose Entities:  Will frequently put REIT offside

The holding by a REIT or any of its subsidiaries of a mortgage (or other security) of an entity will potentially cause the REIT not to qualify as a REIT if the mortgage (or other security) has a fair market value of more than 10% of the equity value of that entity.  Since it is common for real estate to be purchased by special-purpose entities (which may have few assets other than the purchased property), it will be common for vendor take-back mortgages held by a REIT or its subsidiaries to cause the REIT not to qualify as a REIT.

7.  Property not Ancillary to Rental Operations (e.g., Mortgages):  Will likely put REIT offside

Given the level and scale of the activities of a REIT and its subsidiaries, their Canadian assets (including mortgages) likely will be considered to be used in the course of carrying on a business in Canada.  This, in turn, means that these assets will be required to qualify as "qualified REIT properties".  In many cases, they will so qualify on the basis that they are property that is ancillary to the earning of rents or capital gains.  However, other assets - such as mortgages (which are specifically deemed by existing income tax legislation not to be interests in real property) and irrespective of whether or not those mortgages meet the under-10% test referred to in 6 above, and liquid investments that are not dedicated to meeting the working capital needs of rental operations (e.g., a fund that has been set aside to pay distributions to unitholders) - may not be "qualified REIT properties".

8.  Contingent Claims Against Third Parties:  may put the REIT offside

The definition of a security includes contingent rights conferred by another Canadian-resident entity that would give rise to a liability of the entity.  Such rights potentially may disqualify the REIT under the draft legislation, if they would represent more than 10% of the equity value of the other entity.  Accordingly, various types of potential rights of action or other claims of the REIT against third parties may disqualify it.

9.  Non-Resident Subsidiaries:  Will put the REIT offside if limitations exceeded

A REIT can only make limited investments abroad.  It is not clear why acquiring significant foreign real estate assets should disqualify a trust as a REIT.  The Canadian foreign affiliate rules are designed to permit Canadian corporations to invest abroad on a basis that is competitive with companies in other jurisdictions, and the foreign property rules, which formerly restricted pension funds and tax deferred plans from investing abroad, have been repealed.  What then is the policy behind effectively prohibiting Canadian REITs from making significant real estate investments abroad?

10.  Other Technical Issues:

The draft legislation contains various technical anomalies that we do not discuss further.

Implications

There is zero tolerance in the draft legislation for the holding of any assets or securities of a subsidiary that are not qualified REIT property.  Accordingly, in order for REITs to qualify under the draft legislation, they will be required to transfer non-qualifying operations to non-REIT-owned entities before the end of 2010.  Depending on the circumstances, this may result in significant tax costs to unitholders on the restructuring and substantial restructuring costs to the REIT and its unitholders, produce a structure that is commercially cumbersome and raise a host of other legal and governance issues  It is deplorable that the Department of Finance is adopting an approach that will generate these costs and commercial inconvenience, when other jurisdictions (including the U.K. which recently completed a comprehensive review of the world wide REIT regimes in developing its new REIT legislation) have demonstrated that this is unnecessary.

Summary of Tests

In order to qualify as a REIT, a trust must satisfy the following four tests in each taxation year:

1.  It does not at any time in the year hold any "non-portfolio property", other than "qualified REIT property".  The definition of "non-portfolio property" includes  "securities" (a broadly defined term) of a Canadian-resident corporation, trust or partnership (or other "subject entity") that represent more than 10% of the value of the subject entity's shares or other equities, and property used by the trust or subsidiaries in the course of carrying on a business in Canada.

2.  Not less than 95% of its revenues for the year are derived from rent from real property (including "immovable" property in Quebec), interest, capital gains from dispositions of real property, dividends or royalties.

3.  Not less than 75% of its revenues for the year are derived from rent (or capital gains) from real property situate in Canada, or interest from mortgages (or Quebec "hypothecs") situate in Canada.

4.  At no time in the year is the total fair market value of real property situate in Canada, cash, or qualifying Canadian government securities less than 75% of the fair market value of all the trust's units.

The term "qualified REIT property" means:

(a)  real property situate in Canada;

(b)  securities of a subject entity if it "derives all or substantially all of its revenues directly    from maintaining, improving, leasing or managing real … properties that are capital    properties of the trust", including real properties that the trust holds under a co-ownership arrangement;

(c)  securities of a subject entity if it holds no property other than legal title to real property    or ancillary property referred to in (d) below; and

(d)  property that is ancillary to the earning by the trust of rent or capital gains from real properties.

Real property is defined to include interests in real property and securities of an entity that itself satisfies the four tests listed in the definition above of a REIT (but ignoring for these purposes that the particular entity might be a corporation or a partnership rather than a trust, so that securities in a partnership or corporation also can qualify as real property).  However, depreciable property that otherwise would be real property will not generally qualify as real property for these purposes if it is eligible for a higher rate of capital cost allowance (of up to 5% under the current rules, and likely higher after giving effect to the March 19, 2007 federal Budget) unless the property is ancillary to the ownership of real property that is only eligible for such a low rate of capital cost allowance, or it is a leasehold interest in such real property.

Rent from real property is specifically stipulated to exclude payments for services other than the services that are ancillary to the rental of real properties and are "customarily supplied or rendered in connection with the rental" of such properties.  However, fees for managing or operating such properties, any "rent based on profits", and any "payment for the occupation of, use of, or right to use a room in a hotel or other similar lodging facility" are specified not to qualify as rent.

Please do not hesitate to contact Neal Armstrong, Duncan Osborne or Ronald Wilson in our Toronto office (416-863-0900), and Fred Purkey in our Montréal office (514-841-6400) if you would like further information.

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practises nationally and internationally from offices in Toronto, Montréal, New York and an affiliate in Paris and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstance. For particular applications of the law to specific situations, the reader should seek professional advice.