UPDATE ON CANADIAN SYNDICATION OF FOREIGN INCOME PRODUCING PROPERTIES

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1 UPDATE ON CANADIAN SYNDICATION OF FOREIGN INCOME PRODUCING PROPERTIES By: Jack Bernstein Aird & Berlis LLP Toronto The Canadian syndication of foreign income producing properties continues to dominate the Canadian public market. Prior to the introduction of the SIFT rules Canadian income trusts were popular investments for RRSPs and individuals offering regular cash returns in excess of bank term deposit rates. There was a significant erosion to the Canadian tax base due to the historic general trend toward converting taxable Canadian businesses into income trusts, particularly announcements from Canadian media and telecommunications giants. This corporate trend prompted the Canadian government to introduce a series of rules designed to tax publicly traded trusts and partnerships owning certain Canadian businesses as if they were corporations the SIFT Rules. The SIFT Rules DO NOT apply where the Income Trust s income is sourced exclusively outside of Canada. An income fund whose income is sourced exclusively outside of Canada does not threaten the Canadian tax base, which is the raison d être for the SIFT Rules. The SIFT Rules contain a key exception for Canadian REITs. As a result of the SIFT Rules, many income trusts that were not strict REITs converted to public corporations, leaving the retail market with very little product. Canada s capital markets have shown strong current demand for products with a sustainable and stable cash yield which presents a tremendous opportunity to access Canadian capital markets using U.S. or other foreign income-producing real estate in order to: liquidate all or part of a

2 - 2 - portfolio, obtain a potentially higher price for the portfolio, participate in future growth and retain property management. Foreign-sourced, cash-distributing income funds are fast becoming a very attractive option for Canadian investors looking for a tax-efficient and tax-advantaged investment: (a) to date, these investments have been primarily in U.S. rental properties (multifamily residential, industrial and commercial, senior care facilities, and hotel properties). There have also been syndications of properties in France, Germany, New Zealand and Australia; and (b) opportunities also exist for non-real estate businesses (through utilization of internally leveraged trust structure). Importantly, Canadian investors are already familiar and comfortable with the structure as an investment option because of their previous income fund experience. A Cross-Border Real Estate Fund is generally structured as a Canadian trust or a limited partnership that holds an interest in a foreign entity that, in turn, either carries on a business in a foreign jurisdiction or holds a portfolio of yield-producing properties located in a foreign jurisdiction. A relatively recent phenomena is the Cross-Border Real Estate Investment Trust comprised of properties located in the United States: (a) Cross-border funds that comprise European properties have also more recently evolved; and

3 - 3 - (b) Cross-border REIT with properties located throughout France, Germany, New Zealand and Australia have also recently materialized. The key to the structure is minimizing or eliminating domestic U.S. or other foreign taxation to extent possible. In a previous article, I analyzed one structure which was a publicly traded income trust owning a U.S. Delaware Corp. (a C. Corp). The strategy was to use interest bearing loans to the Delaware Corp. subject to U.S. income stripping and thin capitalization rules, to strip out income without U.S. income tax or withholding tax, the objective being to use leverage to approximate the economics of a REIT. The other structure was a publically traded Canadian limited partnership owning a U.S. REIT. This structure allowed distribution from the U.S. to only be subject to U.S. withholding tax if distributions were made to partners other than Canadian pensions. It also avoided U.S. FIRPTA. One concern with the structure is that the market for a publicly traded Canadian limited partnership may not be as strong as a fund formed as a trust. Canadian limited partnerships must be publicly traded for U.S. REIT statute. A third structure has emerged using a Canadian income trust which also qualifies as a REIT for U.S. domestic purposes. The structure used in Milestone Apartments REIT is interesting because of the dual character of the top-level entity which we have labeled, the Dual income trust U.S. REIT structure. A Canadian mutual fund a trust is formed which also qualifies as a U.S. REIT. The trust forms a LLC or a disregarded U.S. REIT subsidiary which invests in U.S. property. There are two options being the formation of a U.S. LLC or U.S. REIT Sub which are disregarded for U.S. tax purposes.

4 - 4 - The Canadian income trust is deemed under the U.S. inversion rules to be a U.S. corporation. Provided it meets certain conditions under U.S. tax law, the Trust is able to elect to be treated as a REIT for U.S. tax purposes. The U.S. REIT is not taxable in U.S. provided it distributes sufficient income to owners. The distributions by the Trust to taxable Canadian holders will be subject to U.S. withholding tax, but should be creditable against Canadian tax payable by such holders on the trust income (a portion of which will, for Canadian purposes, be dividends from the U.S. REIT Sub i.e. foreign source income earned through the Trust). The distributions to tax-exempt holders in Canada will not be subject to U.S. Tax. The Trust not taxable in Canada provided it distributes sufficient income to its owners. The structure is intended to avoid FIRPTA to the extent a holder keeps its interest below 5%. The existing partners can transfer into an Up-REIT structure Class B securities are exchangeable for and economically equivalent with units of Trust. From a Canadian perspective, the income trust will earn income in respect of and on the shares of its wholly-owned U.S. subsidiary. The trust will earn dividend income on the LLC or shares of the REIT subsidiary. The trust may receive returns of capital in respect of amounts originally invested in the subsidiary. Depending on the number of employees employed by the U.S. subsidiary, the Canadian FAPI rules, may or may not be engaged at the trust level, but the consequences of these rules is manageable given the general intention to distribute the partnership s underlying rental income up and through the sub in real time. The trust would distribute its income to its investors, claim a deduction in respect of such distributed income, and

5 - 5 - avoid entity level taxation in Canada and distribute excess cash in the form of tax-free returns of capital creating an additional Canadian tax-advantage for taxable investors. From a U.S. perspective, the intention is for the trust to be classified as a corporation for U.S. purposes under the regulations and, most essentially, to structure the trust s acquisition of the real property portfolio interest in a manner that triggers the application of the U.S. anti-inversion rules. This may require the acquisition of an existing trade or business. For example, the trust might, through its wholly-owned, but disregarded U.S. subsidiary, use the net proceeds from an IPO to acquire a partial interest in a pre-existing partnership with a real property rental business. If the existing partners don t want to trigger immediate tax on the sale of the REIT, the existing or remaining partners might then exchange their interests in that existing partnership for, or have their interests reclassified into, partnership interests that are economically equivalent to the units of the trust and generally exchangeable for Units of the trust turning the structure into what is colloquially referred to as an Up-REIT structure. If the units issued on the IPO are disregarded and if the exchangeable, economically equivalent partnership interests are considered stock of the Canadian-organized trust for purposes of the anti-inversion rules, then it may be the case that the partners of the pre-existing partnership will be considered to hold the requisite amount of stock of the Canadian-organized trust in order to trigger an inversion. The objective in triggering the anti-inversion rules is to cause the trust to be treated as a U.S. corporation for all purposes under the Internal Revenue Code, with the result that it may be permitted to elect to be treated as a REIT for U.S. purposes notwithstanding that it is a Canadianorganized trust.

6 - 6 - Assuming an inversion is triggered and the other substantive requirements for REIT status in the U.S. are attained (such as meeting the share ownership test, the requisite asset tests, gross income tests and annual distribution requirements), each being a matter for U.S. counsel to opine, the U.S. would see a U.S. REIT carrying on a rental business. The REIT generally will not be subject to tax in the U.S. provided it distributes sufficient income to its investors thereby avoiding U.S. entity level taxation. Ordinary distributions paid by the REIT to Canadian investors will generally be subject to U.S. withholding tax, which should be levied at 15% for qualified Canadians and generally exempt for pension funds. Any U.S. withholding tax paid by a Canadian investor should be eligible for foreign tax credit treatment in Canada, provided the investor has sufficient U.S. source income - which should include any dividend income earned by the trust on the shares of the U.S. Sub and designated as having been paid by the trust to the investor. FIRPTA is a consideration in respect of both distributions of the REIT sourced from gains of U.S. real property interests and gains realized by investors in connection with the sale of units of the REIT, which might be expected to be treated as a U.S. real property holding corporation - However, FIRPTA will not apply in respect of either to the extent that the particular Canadian investor s ownership (or constructive ownership) interest in the REIT is limited to less than 5% of the units of the REIT during the relevant testing period. Some additional interesting features of this structure include: (a) It does not rely on leverage for shelter, which eliminates associated uncertainties and risks, such as setting an appropriate interest rate on a loan from a REIT to a U.S. subsidiary and trying the marry the amount of debt and related interest

7 - 7 - expense with projected revenue less other projected shelter, which may vary with time; and (b) Canadian withholding tax would normally apply in respect of trust distributions made to non-canadians, but qualifying U.S. investors should be exempt from such withholding tax under the Canada-U.S. Treaty provided the Canadian trust s income is considered to be sourced from outside Canada (i.e. the U.S.). Inovalis REIT was formed to acquire properties in France and Germany. A Canadian mutual fund trust (REIT) acquired common shares and both interest bearing and non-interest bearing notes in a Luxembourg holding company ( Luxco ). There will be 15% equity in Luxco. Inovalis acquired exchangeable security in Luxco which were exchangeable for units of the REIT. Luxco formed single purpose Luxembourg companies for the German properties and indirectly single purpose French companies (SPV) for the French properties. The French companies are owned by an OPCI incorporated under the form of a PPICAV. Luxco loans funds at interest to the French company. There is no French withholding tax on the interest payments. The French SPVs purchase lessees rights to use the property and the lessors promise to sell. The lease payments approximate what would otherwise be mortgage payments. There is a 5% registration duty on the price allocated to the right to use the building. The French SPV and withholding vehicle which complies with distribution obligations are exempt from French corporate tax. There is no withholding tax by French SPV to the OPCI. There is a 5% French withholding tax on dividend distributions by the holding vehicle (OPCI) to Luxco. Capital gains realized by the French SPVs/OPCI on the sale of real properties would be exempt from corporate

8 - 8 - income tax provided the OPCI distributes 50% of the capital gain. Distributions are subject to 5% withholding. A sale of shares of the French SPV owned by the OPCI won t be subject to withholding tax on capital gains realized by Luxco. There may be an exemption from the 3% tax on real estate. In Germany, the German SPV will hold a purchase option and a usufruct??? (right to use). The German SPV will acquire the head lease or the subleases. The interesting feature of this REIT is the investment in head lease contracts with prepaid rent coupled with an option to purchase. The use of head lease would not trigger a disposition of the properties thus avoiding German land transfer taxes (or deferring land transfer taxes until the option to purchase the properties was exercised). There is no German withholding tax on the lease payments. The use of head lease avoids a permanent establishment in Germany which would have trigger a municipal tax of 7% to 17.5% depending on the municipality. In addition, the prepaid rent is deducted over the term of the lease (in essence there is a write off of both land and building which presumably exceeds the deduction for depreciation which would only be for the building). Interest is also deductible subject to limitations. The first $3 million euros of annual interest is deductible. There would be no capital gains tax in Germany if the shares of the German SPV were sold

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