With a record breaking 2012 in real estate investment trust ("REIT") activity, the New Year sees no signs of letting up. Close to $7 billion of new debt and equity was issued in the real estate capital markets in 2012, and 2013 is keeping pace, with an even higher proportion of real estate issuances relative to total equity issuances.
Supporting this growth, new proposed legislative tax changes to enhance Canada's REIT regime are more than welcomed by the industry and provide even greater flexibility in forming and managing REITs. In addition, Canada's favorable tax treatment of foreign-based assets and activities are permitting the emergence of a new breed of cross-border REITs.
Q1 2013 will mark another stellar period for Canadian REIT activity with several offerings that were closed including:
- Agellan Commercial REIT raising $134.6M
- American Hotel Income Properties REIT LP raised $95.7M
- Milestone Apartments REIT IPO raising $200M
- Allied REIT offering raising $110M
- RioCan REIT offering debentures of $250M
- Dundee Industrial REIT raising $100M
In addition to the above, several other prospectuses have been filed or are pending filing as well as other major transactions including:
- the proposed takeover of Primaris Retail REIT
- the anticipated creation of the Loblaws REIT
- the acquisition of 100% of the units of KEYreit by Huntingdon Capital Corp.
- preliminary prospectus filings by Melcor REIT on the domestic front, and for WPT Industrial REIT and Starlight U.S. Multi-Family Core REIT both with US based assets, industrial and multifamily respectively.
- Several other new domestic and cross-border REITs that have not yet come to market
Underlying this flurry of activity is an investor appetite for yield at both the individual and institutional level. The so called "cash sitting on the sidelines" hungers for healthy returns and the REIT sectors performance in 2012 proved to be well in excess of the S&P/TSX composite index.
A trend to note is that a significant portion of funds raised are being deployed south of the border in various asset classes including Office, Hotel, and Multi-residential. Of course, structuring such acquisitions is always interesting from a tax and legal perspective, attempting to integrate two already complex tax and legal systems to achieve business objectives and tax efficiencies, a topic beyond the scope of this article.
Advantages of REITs
One of the most significant advantages of a REIT is their tax flow-through nature. In 2006, the federal government introduced a new tax regime that imposed a tax on specified investment flow-through trusts ("SIFT") akin to that of a corporation, but contained an exception for REITs, albeit a narrow and complex exception. In addition, foreign based assets and activities could generally be established to be exempt from SIFT taxation, with proper structuring. Qualifying for these exceptions has allowed REITs to distribute their income to unit holders without being subject to entity level tax. Keep in mind a significant number of REIT investors are tax exempt entities or individual investors acquiring units through their RRSPs or other tax deferred plans, allowing for income to be earned by the investor on a tax-deferred basis which further amplifies the after-tax return on investment.
Besides the tax advantages, REITs offer investors an opportunity to passively hold highly liquid investments in real estate, generally targeted at specific market segments, whilst providing stable tax efficient cash flows with the potential for long term appreciation, without the headaches of having to actively manage real estate.
For existing direct investors in real estate, REITs offer a unique opportunity to access capital markets for expansion or as a full or partial exit plan.
New REIT Rules
Failure to qualify as a REIT under the specific rules could subject the trust to "SIFT tax" which is intended to apply a tax to the trust that would equate what a corporation would have otherwise paid.
On October 24, 2012, Canada's Department of Finance introduced proposed amendments to the Income Tax Act (Canada) to clarify the rules affecting REITs and in certain cases to alleviate some of the stringent requirements to qualify and maintain REIT status. As background, very generally to qualify as a REIT, a REIT was required to meet the following four tests: 1) Property test, 2) Passive revenue test, 3) 75% Real property revenue test, and 4) Qualifying property value test. As part of the amendments:
- A fifth test has been added being the "publicly traded test".
- Previously under the "Property Test" a REIT was not permitted to hold any non-portfolio property at any time during the year other than qualified REIT property. The new rules amend the property test to allow REITs to hold up to 10% in non-portfolio property assets that are not qualified REIT property. This provides REITs with some wiggle room to invest in "bad assets" (non-qualifying real estate, property used in carrying on a business, certain securities etc.)
- Previously under the "Passive Revenue Test", a REIT was required to derive 95% of its gross revenue from rent, interest, dispositions of real estate, dividends, and royalties. The amendments include the reduction of the threshold from 95% to 90% and the inclusion of gains from dispositions of "eligible resale properties" in the gross revenue amount.
- The amendments clarify that for the purposes of determining "gross REIT revenue" under the passive revenue test, the character of certain amounts received or receivable from certain entities including qualifying subsidiary corporations will flow-through in determining the "gross REIT revenue" of the trust.
The above are only select summary points from some of the proposed amendments; a more comprehensive outline of the rules can be found at the following link: http://www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/TNF/Pages/tnfc1304.htm
All in all, the changes provide for greater flexibility in qualifying as a REIT and maintaining REIT status. Further, the rules may expand the scope of the types of investments a REIT can make without being subject to the SIFT tax. Accordingly, we may see more REITs being formed by groups that may not have fully qualified under the old rules, as well as some additional (albeit limited) degree of REIT activity in areas that REITs were forced to stay away from before the new changes.
The information contained above is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.
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Pav Sikham, CA
Senior Manager, Tax, Real Estate
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