Executive summary
The benefit of a real estate investment trust (“REIT”) from a Canadian tax standpoint is flow through treatment allowing investors to maximize returns. Structured and maintained properly, a REIT will effectively be non-taxable at the trust level. Whether it makes sense to structure a fund as a REIT depends in part on the ability to achieve various conditions provided in Canada’s Income Tax Act, including revenue and asset tests, and have systems in place to monitor these thresholds throughout the year.
A REITis a complex entity that provides an opportunity to invest in real estate in a tax efficient manner. Since 1993, Canadian REITs have offered investors a stable income from real estate holdings, covering asset classes such as office, retail, industrial and residential.
The benefit of a REIT from a Canadian tax standpoint is flow through treatment allowing investors to maximize returns. Structured and maintained properly, a REIT will effectively be non-taxable at the trust level. However, the trade-off is a complex compliance burden, with significant consequences if requirements under the under the Income Tax Act (the “Act”) are not adhered to on an ongoing basis.
The structure of a REIT
A REIT must be structured to comply with provisions under the Act governing trusts, unit trusts, and mutual fund trusts (“MFT”) and must also be resident in Canada throughout each taxation year. REITs must also meet revenue, asset, and public ownership tests. Ensuring that a trust qualifies as a REIT will also exempt the structure from the Specified Investment Flow-Through Trust rules (“SIFT”), discussed more below.
- Qualifying as a MFT: A trust will qualify as an MFT if its only undertaking is holding, maintaining, improving, leasing or managing of any real property or of any immovable property that is capital property, or investing of its funds in property. The trust must also be a “unit trust” resident in Canada, with units qualified for distribution to the public. Broadly speaking, unit trusts are inter vivos trusts and describe the interest of each beneficiary by reference to its units. They can be open-ended or closed-ended under the Act, with the latter having more stringent conditions on the type of property and income earned, while the former requires a specific redemption right for unit holders. The majority of Canadian REITs are open-ended. Generally, the requirement that units are qualified for distribution to the public can be satisfied if is a prospectus or similar document filed with a securities commission in Canada allowing a lawful distribution of units. Last, an MFT must have at least 150 unitholders of any one class of units who own at least “one block” of units of that class having a minimum fair market value of $500.
- Monitor non-resident ownership: Importantly, if more than 10% of a trust’s property is Canadian real estate (or certain other properties), and the trust is established primarily for the benefit of non-resident persons, then the REIT will be deemed not to be an MFT. The test to determine if an MFT is established primarily for non-resident persons is a 50% fair market value test. As greater than 10%of the value of a REIT will most likely be Canadian real estate, it is important for REITs to monitor non-resident ownership of units.
- The SIFT rules: If a publicly traded income trust does not qualify for the definition of a REIT under the Act, then it risks being subject to SIFT rules. Generally, SIFTs are taxed similar to corporations. They are subject to income tax meant to approximate a combined Federal and Provincial corporate income tax rate. Distributions are treated as taxable dividends for beneficiaries.
REIT asset tests
For practical purposes, it is in the REIT’s best interest to ensure that 90% and 75% asset tests are met throughout the taxation year. This is distinguishable from revenue tests which are determined at the end of each tax year. As a result, revenue tests may occur on a quarterly basis.
- The 90% asset test: At each time in a taxation year, 90% of the total fair market value of non-portfolio properties must be qualified REIT properties.
- Non-portfolio property: Non-portfolio property refers to securities of entities (subject entities) of which a REIT holds 10% or more of the fair market value, or 50% thereof when the interest is grouped with that in entities affiliated with the subject entity. Additionally, non-portfolio properties include Canadian real, immovable or resource properties if at any time in the taxation year those make up 50% of the equity value of the REIT. Finally, if the REIT, or a person or partnership that does not deal at arm’s length holds property in the course of carrying on a business in Canada, this will qualify as non-portfolio property.
- Qualified REIT property: Generally, qualified REIT properties include, those held by the trust, that are: real or immovable property that is capital property; an indebtedness of a Canadian corporation represented by a bankers’ acceptance; property ancillary (other than an equity of an entity or certain debt instruments) to earning rent real or immovable properties or income from dispositions thereof; certain other investments that are qualified investments for deferred profit-sharing plans; real or immovable property other than capital property if that is contiguous with a real property or immovable property held as capital, and also ancillary to the holding of that capital property (“Eligible Resale Property”); or deposits with a credit union.
- Subsidiaries as qualified REIT property: Securities of subject entities can also satisfy the definition for qualified REIT property. Subject entities may qualify if they provide property management or related services to the real or immovable property of the REIT and earn 90% of their gross revenue from those sources. Also, subject entities can be used to solely hold legal title to real or immovable properties of the trust or properties ancillary to earning rent or interest—in other words, “bare trustees” of the certain REIT properties.
- The 75% asset test: 75% of the trust’s equity value throughout the tax year is made up the following: a real or immovable property that is capital property; Eligible Resale Property; indebtedness of a Canadian corporation represented by a banker’s acceptance; certain other investments that are qualified investments for deferred profit-sharing plans; and deposits with a credit union.
REIT revenue tests
Along with the asset tests, REITs must also comply with annual revenue tests. There are two revenue tests: the 75% test and the 90% test.
- The 75% revenue test: At least 75% of a REIT’s gross income must be derived from: rents from real or immovable properties; interest on obligations secured by mortgages (or hypothecs) on real or immovable properties; and proceeds from the sale or other disposition of real or immovable properties that are held on capital account.
- The 90% revenue test: This test covers both real estate and portfolio income, including rent from real or immovable properties; interest; proceeds from dispositions of real or immovable properties that are capital properties; dividends; royalties; and dispositions of Eligible Resale Properties.
Distributions from a REIT
Residents of Canada
- Income and capital gains: A REIT will usually distribute all of its income and net taxable capital gains by the end of each tax year, which can be deducted from the REIT’s income. The commercial drafting for a trust deed may provide this as a requirement to ensure that REIT remains effectively non-taxable. Income and taxable capital gains will generally retain their character at the investor level.
- Return of capital: Returns on capital (“ROC”) are not subject to tax to the investor, however, will result in a grind to the adjusted cost basis of units such that a disposition of the investment may be subject to a higher incidence of tax in the future. The benefit is that ROC is generally received tax-free in the year of distribution, which provides a deferral advantage to investors.
Non-residents of Canada
- Income: Distributions of income to non-residents from a REIT are generally subject to a withholding tax at 25%, which may be reduced under an applicable tax treaty.
- Capital gains: On the distribution of taxable capital gains to non-residents, withholding tax at a rate of 25% will apply as if the trust has taxable Canadian property gains.
- Return of capital: A distribution of capital from a REIT to a non-resident is generally subject to a 15% withholding tax if more than 50% of the fair market value of the unit is attributable to one or more properties each of which is real property in Canada, a Canadian resource property or a timber resource property. Depending on certain losses attributable to their investment, a non-resident may file a specific income tax return to claim a refund of this withholding tax.
To REIT or not to REIT?
Whether it makes sense to structure a fund as a REIT depends in part on the ability to achieve conditions of the Act on an ongoing basis and properly monitor these thresholds throughout the year. It is important for REITs to have sufficient testing mechanisms in place such that they do not fall offside the Act. The benefit of this trade-off from a tax perspective is the opportunity for large-scale investment in real estate asset classes with a flow through structure. RSM can help analyze and determine optimal structuring of a REIT based on asset class and investment strategy, and support continuous compliance.
