Update on Income Trusts: Halloween Trick becomes Holiday Treat
January 7, 2008
James G. Morand
Gabrielle M.R. Richards
The Minister of Finance delivered an early holiday gift on December 20, 2007 to certain income funds and their investors when he announced technical amendments to the specified investment flow-through (SIFT) rules released October 31, 2006 (and enacted in June 2007).
The SIFT rules treat "publicly traded" entities (income trusts and certain Canadian partnerships) in much the same manner as corporations. SIFTs that were in existence on October 31, 2006 will not be subject to these rules until 2011, subject to compliance with the normal growth guidelines. As discussed in our previous article, income from a business carried on in Canada, as well as income and gains from "non-portfolio properties" of such trusts and partnerships, will be taxed in the trust or partnership. The after-tax distribution to beneficiaries or partners will be treated as a taxable dividend received from a taxable Canadian corporation. Excluded from the SIFT rules are certain real estate investment trusts (REITs) that meet certain requirements. It is understood that only four of the approximately 31 Canadian REITs currently meet these requirements.1
The proposed technical amendments clarify the existing SIFT rules, are relieving in nature and address a number of problems that had been identified by income funds and their advisors, particularly in respect of qualifying as a REIT under the SIFT rules. Such clarification does not, however, go so far as to provide relief to oil and gas trusts and other energy trusts. Legislation to implement the proposed amendments will be introduced early in 2008, effective at the same time as the existing SIFT rules.
In general terms, the proposed amendments will address the following:
- Subsidiary trusts or partnerships – Many income funds are structured as trusts, with subsidiary trusts and partnerships holding property or carrying on business. The SIFT rules apply to such trusts, but are also broad enough to cause the subsidiary trusts and partnerships themselves to be considered SIFTs because the publicly traded trust represents "investments" in such trusts and partnerships. The technical amendments will amend the definition of a SIFT to exclude such trusts and partnerships.
- Publicly traded debt – Under the SIFT rules, a trust or partnership will be a SIFT if its debt is publicly traded (for example, through an inter-dealer brokerage system) even if it has no publicly traded equity. The definition of "public trading" will be amended to exclude such debt, provided that it is not equity-like debt (i.e., is not convertible to equity or is not a participating debt interest) and at least 90% of such debt is held by unaffiliated persons. This change is a significant one for many oil and gas partnerships, which have public debt.
- Portfolio investment entities – An issue arises where a publicly traded trust or partnership owns more than 10% of another trust, where the underlying trust itself does not hold non-portfolio property and is not a SIFT. The SIFT rules treat such investment as non-portfolio property of the publicly traded entity, causing it to be a SIFT. The technical amendments will effectively look through the second trust, such that the publicly traded entity will not be a SIFT.
- Investments in Canadian real, immovable or resource property – "Canadian real, immovable or resource properties" representing more than 50% of the equity value of a trust is defined as non-portfolio property. Many publicly traded mutual fund trusts that invest in the Canadian real estate or Canadian resource sectors are SIFTs because the definition of "Canadian real, immovable or resource properties" includes an investment in a corporation, trust or partnership if more than 50% of the fair market value of the investment is derived indirectly from such property. The definition will be amended to exclude shares of taxable Canadian corporations and interests in SIFTs. Thus, a publicly traded mutual fund trust investing in shares of resource corporations will not be a SIFT if the trust holds less than 10% of the shares of a particular resource corporation and if the shares of the particular corporation do not represent more than 50% of the fair market value of the trust (i.e., it otherwise does not hold non-portfolio property).
- REITs – In addition to the foregoing rules, which also benefit REITs, a number of specific relieving technical amendments will be made to benefit REITs:
- Location of property – Currently, REITs cannot own more than 25% of their assets outside of Canada and cannot generate more than 25% of their revenue from such assets. This restriction will be removed, such that REITs will be able to hold real or immovable property anywhere in the world. This change is a significant one for many Canadian REITs, which currently have US assets.
- Rent derived from a subsidiary trust – To qualify as a REIT, the trust must derive at least 75% of its revenue from rent and other specified sources. If the trust holds real estate properties indirectly through a subsidiary trust, this test is arguably not met. The amendments will clarify that rent will not lose its character simply because it is paid through a subsidiary trust.
- "Cash" investment – A REIT must hold 75% of its assets in certain qualifying assets, including cash. The amendments will expand the definition of cash for this purpose to include amounts on deposit with financial institutions, bankers’ acceptances and other highly liquid short-term investments.
- Nominee corporations – Currently, nominee corporations must hold title only to property owned by the REIT or by the REIT together with other entities. The amendments will expand the rules to permit the nominee corporation to hold legal title to property owned by subsidiaries of the REIT.
The amendments address a number of identified problems with respect to the SIFT rules, however, many others still remain to be addressed, possibly in the actual wording of the legislation once it is released in 2008.
1 December 21, 2007 Globe & Mail, Report on Business.