REITS next tax target?
If others follow the example of Loblaws and Canadian Tire, look for the Minister of Finance to pull the plug
canada is starting to see some life in its initial public offerings market again with new large real estate Investment Trusts (reITs) being established by canadian Tire and Loblaws for the purpose of selling real estate at an attractive price. It sounds like a good business opportunity for the retailers to deploy capital for other purposes.
However, more reITs of this nature might give Minister of Finance Jim Flaherty a new policy headache if it leads to corporate sector inefficiency and a loss in the corporate tax base. both issues were prominent factors when Mr. Flaherty put a kibosh to flow-through entities in 2006 that grew to 17% of the stock market capitalization with two major business income trusts — Telus and bell — being proposed.
reITs are the last vestige of the income trust movement as they were exempted from the new laws that make publicly traded flow-through entities taxable at the corporate level (reITs continue to be mutual fund trusts). current market capitalization of reITs in canada is roughly $50-billion — the two new reITs could potentially add another $10-billion down the road.
reIT legislation operates in several other countries such as the united States, Germany, France, u.K. and Australia although tax legislation differs. The policy rationale for reITs is that they provide an opportunity for individuals to directly own widely held real estate assets such as shopping centres rather than being limited to small real estate assets like apartments. In principle, reITs, like the business income and royalty trusts of yesteryear, improve capital market efficiency in this sense.
The clear advantage of a reIT is to reduce corporate and personal taxes on income paid to investors. In the case of canada, a reIT does not pay business tax as long as its taxable income is distributed to unitholders. canadian individual unit holders pay personal income tax on distributions according to the type of income received — lease and interest is fully taxed while any dividends or gains from the disposal of assets are taxed at favourable rates just as in the case of stocks.
returns of capital are exempt of taxation although any reIT distributions of capital reduce the cost basis of units,
Oil companies can sell off service centres and banks their branches
leading to capital gains taxes when units are sold.
Pension plans do not pay tax on distributions (as with other investment income) and any foreign shareholders (ownership must be less than 50%) pay canadian withholding taxes on reIT distributions (at most 25% although typically reduced to 15%). Non-residents may be able to credit withholding taxes on distributions if such distributions are taxable.
However, several restrictions have applied to reITs that have limited their use so far. Generally, various “tests” limit reIT investment to earning rents, mortgage interest and gains from disposing real property. Although 10% of income can come from non-qualified sources, it is difficult for some companies such as hotels to operate as reITs when earning non-qualifying income from restaurants and catering.
However, Loblaws and canadian Tire figured out that they could put their real estate assets in a reIT whose primary income is derived from just immovable property. corporate tax on such income is avoided. canadians will pay more tax on reIT distribution than on dividends and they’ll pay capital gains from shares; non-residents will have favourable tax treatment since the tax on distributions is less than corporate and personal taxes on income derived directly from shares in Loblaws and canadian Tire.
So if the smart tax planners at two notable retail firms can figure out this tax advantage to sell assets at a better price, why don’t others? Oil companies can sell off service centres and banks can put branch real estate in a trust. Industrialists could lease real estate instead of owning it, which is more common in the united States than in canada.
There is a lot of real estate out there — $1.7-trillion in public and private nonresidential structure assets. Not everything will be put in a reIT but the tax benefits of doing so might be welcome to several companies looking to reduce tax costs and increase capital funding.
However, hiving off real estate assets to a reIT can initially provide new capital but starve a company of some cash flow in the longer run. cash flow is important if the company is looking to develop major investment projects or undertake an acquisition. Otherwise it must rely on debt or issue more shares or units to investors. And not all companies can create reITs like this, giving them a tax advantage on their competitors.
This tax file is one to watch.