Brooks

By S. Michael Brooks

In a surprise move that rocked Canadian capital markets, the conservative government of Prime Minister Stephen Harper proposed a tax on business income trusts as well as oil and gas royalty income trusts after the market closed on Oct. 31, 2006. In the announcement, Canadian REITs were exempted from the new income trust tax, but were more narrowly redefined in the process.

The proposal brings the Canadian REIT closer to the U.S. model, with 75 percent and 90 percent qualifying income tests, and a 75 percent qualifying asset test. Certain elements of the draft rules are controversial, including a 25 percent limit on foreign assets and a limit on ownership of higher-category depreciable assets. More importantly, there were no proposals equivalent to the U.S.-style taxable REIT subsidiary (TRS) or qualifying REIT subsidiary (QRS) rules, both of which are necessary for Canadian REITs to carry on the business of owning income-producing real estate in a similar manner to the U.S. model.

The announcement, prompted by rumors of large corporate conversions to trust status, contradicted a conservative election promise not to tax income trusts. While several political parties in the House of Commons are in favor of closing the perceived tax loophole that allowed operating corporations to convert to trusts and thereby avoid corporate income tax, the opposition is using the announcement to criticize the government. The opposition parties are proposing minor amendments to the legislation that the government is resisting, including a longer phase-in period and a reduced tax rate.

Canadian REITs	Symbol Ticker
Alexis Nihon REIT	AN.UN
Allied Properties REIT	AP.UN
Boardwalk Real Estate Investment Trust	BEI.UN
Brookfield Properties Corporation	BPO
Calloway REIT	CWT.UN
Canadian Apartment Properties REIT	CAR.UN
Canadian Hotel Income Properties REIT	HOT.UN
Canadian REIT	REF.UN
Chartwell Seniors Housing REIT	CSH.UN
Cominar REIT	CUF.UN
Dundee Real Estate Investment Trust	D.UN
H & R REIT	HR.UN
InnVest Real Estate Investment Trust	INN.UN
IPC US REIT	IUR.UN
Legacy Hotels REIT	LGY.UN
Morguard Real Estate Investment Trust	MRT.UN
Northern Property REIT	NPR.UN
Primaris Retail REIT	PMZ.UN
RioCan REIT	REI.UN
Sunrise Senior Living REIT	SZR.UN

One of the amendments in the proposal includes items, such as a TRS mechanism mentioned above, that would enhance REITs' functionality. Also, given that Canadian REITs are trusts (and not corporations electing REIT status annually as in the U.S.), management activities are often conducted through wholly-owned corporate subsidiaries or limited partnerships. These subsidiaries do not qualify under the exclusions to the "non-portfolio property" rules—which themselves are designed to limit the REIT exemption—and most existing REITs would not qualify without restructuring.

The Real Property Association of Canada (REALpac), NAREIT's Canadian counterpart, has met with the government to explain the new rules' impact on the existing REIT industry, and to advocate for the changes noted above. As in the U.S., however, there are challenges that come with requesting change. For example, the oil and gas royalty trust sector argues that it, too, should be entitled to a REIT-style exemption. The business income trusts argue that the government's case against them (tax leakage) is fundamentally flawed and they should be grandfathered.

In a report released on Feb. 28, 2007, the Commons Finance Committee recommended that the government publicize its tax revenue-loss methodology and data, and either reduce the trust tax or extend the tax phase-in period by 10 years. Both of these recommendations are important to Canadian REITs, some of which may find themselves technically outside the new rules, if passed unamended.

The Commons Finance Committee report has become politicized, as each political party wrote either a dissenting opinion or an opinion critical of the conservative government. In response to pressures from the oil and gas industry, the business income trust sector and the opposition political parties, the conservative government proposes no changes to the proposed rules.

Canadian REIT Industry
Equity Market Cap. (In Millions of U.S. Dollars)	$31,167
Percent of FTSE EPRA/NAREIT Global Real Estate Index	3.33%
Number of Companies	20
NAREIT data as of Mar. 31, 2007

Canadian REITs are thriving despite this political environment, with substantial gains in market capitalization and share values since the October 2006 announcement. Several have been taken private by pension funds, life insurance companies or other large real estate operating companies. Still more small REITs have sprung up to fill the gap, and the rest continue to make accretive acquisitions.

Canadian REITs have a bright future ahead, with strong investor support, and many opportunities for growth. With a few tweaks to the pending legislation, Canadian REITs will have a legislative platform comparable to U.S. REITs from which to conduct business.