Qualifying Criteria for Real Estate Investment Trusts Expected to Improve in 2011
Real estate investment trusts (“REITs”) are publicly-traded trusts that are considered attractive investment vehicles because they offer an exemption from the tax on distributions from specified investment flow-throughs. In December 2010, the federal government announced several proposed changes to the income tax rules applicable to REITs, a number of which will be of significance to the commercial real estate community.
The proposed amendments are chiefly concerned with the criteria that investment trusts must meet in order to qualify as REITs. Expected to come into force in 2011, these amendments will also be applicable on an elective basis for post-2006 taxation years if certain conditions are met. A brief overview of the most notable elements of the proposed amendments is provided below:
i. Qualified REIT Property
Under the current rules, REITs are generally prohibited from holding any “non-portfolio property”, being investments other than “qualified REIT properties”, at any time in the taxation year. Perhaps most significant of the amendments is an allowance permitting these trusts to hold up to 10% of their non-portfolio property in assets that are not qualified REIT properties without losing their status.
“Non-portfolio property” typically includes:
- property used in carrying on a business; and
- securities of an entity that represent more than 10% of the equity value of the entity or more than 50% of the equity value of the security holder.
Under the current rules, “qualified REIT property” includes:
- real or immovable property;
- property ancillary to earning of rents and capital gains from dispositions of real or immovable property; and
- some types of qualifying subsidiaries.
This welcoming allowance provides a much needed degree of flexibility and safe harbour for REITs that face unexpected or unintended property issues.
ii. Source and Nature of REIT Revenue
In order to qualify as an REIT, an investment trust must meet two tests designed to determine the nature of its revenue. The current qualification rules require that at least 95% of an REIT’s revenue be derived from passive sources and that at least 75% come from certain passive real estate sources. The proposed amendments reduce the 95% passive revenue source requirement to 90% and clarify that, for both tests, revenue is to be defined as gross revenue inclusive of capital gains.
The proposals go on to clarify that, for purposes of the two thresholds tests referred to above, amounts paid by certain subsidiaries of an REIT to the REIT will have the same character as it had when it was received or earned by the subsidiary. It is expected that this change will serve a beneficial clarification for tax planning purposes.
iii. Foreign Currency Gains
When REITs hold foreign real or immovable property, they may finance the acquisition of such property using debt denominated in a foreign currency. Given the potential foreign currency risk in holding foreign assets, REITs may choose to enter arrangements in an effort to hedge that risk. To that effect, the proposed amendments will allow REITs to earn, as qualifying revenue, gains realized from foreign currency fluctuations in respect of revenues derived from foreign real or immovable property, exposing investors to additional revenue sources.
While the final form of these proposed amendments remains to be seen, collectively they appear to improve the attractiveness of real estate investment trusts for those looking beyond securities. By providing both clarification and improved qualification thresholds, the amendments modify the rules governing REITs in a manner that better reflects the practical realities within which these investment vehicles operate.
Entitlement to Post-Closing Property Tax Refunds: 80 Mornelle Properties Inc. v. Malla Properties Ltd.
80 Mornelle Properties Inc. (the “Vendor”) was the owner of an apartment building in Toronto prior to selling it to Malla Properties Inc. (the “Purchaser”) in October 2006. Before the sale, the Vendor retained lawyers to appeal the property’s tax assessment and continued to pursue the assessment appeal well after the transaction closed. The Vendor was eventually successful in this reassessment, with the result that a tax refund of $251,166.43 was owed for the period of 2003 to 2006.
The City of Toronto paid this refund to the Purchaser in compliance with section 306(2) of the City of Toronto Act, 2006. This section provides that property tax refunds are to be paid “to the owner of the land as shown on the tax roll on the date that the adjustment is made”. Upon learning of the refund, the Vendor asked the Purchaser for the refund less the portion of it that related to the period after the sale. When this request was refused, the Vendor commenced an application to force the Purchaser to disgorge a majority of the refund.
At trial, the application judge determined that, at the time the property was sold, the most that the Vendor could be said to have in respect of its assessment appeal was a “contingent prospect for receiving a tax refund in an amount yet to be determined”. As the Vendor could not have sued on the basis of such an interest, the Court concluded that this interest did not constitute a chose in action. The application judge then considered whether the doctrine of unjust enrichment could be leveraged so as to require the Purchaser to disgorge the refund. Although the case law favoured the Vendor on this point, the Court concluded that the operation of section 306(2) of the City of Toronto Act, 2006 (requiring payment to the owner of the land as of the date that the adjustment was made) constituted a juristic reason for the Purchaser’s enrichment.
The Court of Appeal reversed this ruling. It held that the Vendor’s application should succeed on the grounds that it both overpaid taxes on the property during the period in which it was the owner and took the necessary steps to have the taxes reassessed. Ultimately, the right to receive the proceeds of the assessment appeal was a chose in action – an intangible personal right enforceable by legal action. This chose in action did not automatically run with the property when it was sold and, as the Vendor did not explicitly assign this right to the Purchaser, it retained its entitlement to the refund notwithstanding the sale.
The Court of Appeal then considered whether the City of Toronto Act, 2006 should operate as a bar to the Vendor’s application. Writing for the Court, Gillese J.A. observed that nothing in the legislation indicated that the legislature intended to interfere with the rights of property owners. Since express wording is necessary if the courts are to interpret legislation as having adversely affected a person’s rights, it could not be said that the legislature intended section 306(2) to strip the Vendor of its right to sue for the refund. Given the findings that the Vendor retained a chose in action and that the City of Toronto Act, 2006 was not a juristic reason for the enrichment, the Purchaser was ordered to disgorge the refund less the portion of it that related to the period after the sale.
The Court of Appeal’s decision is consistent with the practice on a real estate transaction. In a typical transaction the parties would have specifically dealt with this matter by an undertaking of the Purchaser to pay over to the vendor the appropriate share of any refund if and when received.