by Karrin Powys-Lybbe, Simon Knowling and Corrado Cardarelli
In Torys’ Capital Markets 2012 Mid-Year Report, we wrote about cross-border income funds (CBIFs) and predicted that there would be more CBIF transactions in the future, including, in particular, CBIF transactions involving cross-border real estate investments. This past year has seen a strong continuation of this trend.
To recap, Canada’s tax laws were changed following the announcement on October 31, 2006 to provide for the concept of a "SIFT trust" and to subject a SIFT trust to an entity level tax that would emulate a corporate level tax. A SIFT trust is defined to include a publicly traded trust that owns "non-portfolio property" (NPP). In turn, NPP is defined to include an interest of 10% or more in securities of a Canadian corporation, a Canadian trust or a partnership that has a sufficient nexus to Canada, and any property that is used in carrying on a business in Canada. There are two main exceptions to the concept of a SIFT trust. The first is an explicit exception for a "real estate investment trust" (REIT). The second is a more subtle exception that derives from the definition of NPP itself and applies to trusts that directly or indirectly carry on business or own assets entirely outside Canada. The SIFT rules are therefore clear that a trust that carries on business or owns assets only outside Canada will not be subject to the SIFT rules, even if the interests it owns in Canadian corporations, trusts or partnerships have a nexus to Canada.
The REIT exception is by now fairly well understood and does not generally include real property ownership limitations that restrict real property situated in Canada. Indeed, recent proposed changes provide recharacterization rules that will make it easier for a trust that owns real properties outside Canada to meet the REIT exception tests. These rules will recharacterize revenues in the form of dividends on shares or interest on debt into rent from real property (for the purposes of one of the REIT exception tests). In this way, these revenues become "good revenues" for the REIT exception tests if the interest or dividend payments are ultimately derived from rent from real property. This will make it easier to structure interests in foreign real property to meet the REIT exception tests. These recharacterization rules are fairly new and have not yet been relied on to their fullest extent. It remains to be seen whether they will be a factor in subsequent transactions.
With respect to public offerings in Canada of CBIFs involving U.S. assets and businesses, the biggest challenge has been trying to find a way around the U.S. so-called inversion rules. These rules will generally apply when the U.S. owners of the business being taken over by a foreign entity (such as a Canadian income fund) have a retained interest in the U.S. assets/business being taken public. The existence of a retained interest, in turn, normally depends on whether (a) the U.S. business/assets can be taken public all at once, providing a complete monetization for the owners; or (b) whether the market will permit only a partial sale (or the underwriters require the owners/promoters to continue to have skin in the game in the form of a retained interest for a period of time following the initial public offering). In general, a retained interest by the former U.S. owners at the level of the income trust or an equivalent interest in one of its subsidiaries (including at the level of the U.S. assets/business) will result in the income trust being "inverted" under the U.S. tax rules if the U.S. owners are considered to own an interest of over 80% in the income trust (disregarding for this calculation interests obtained in the public offering). Interests in subsidiary entities are considered equivalent to an interest in the public trust for this purpose if the retained interest holders have distribution rights that are substantially equivalent to the distribution rights of the holders of the public income trust securities. When inversion is found to occur, the Canadian income trust is treated as a U.S. corporation for U.S. income tax purposes. This means that the income trust would be subject to U.S. tax on its worldwide income, and distributions paid to Canadian unitholders would be subject to U.S. withholding tax (with the associated issues of whether such withholding tax would be at treaty-reduced rates and whether Canadian unitholders would be entitled to a foreign tax credit for the U.S. withholding tax).
One of the clear exceptions to the U.S. inversion rules is an income trust that has "substantial business activities" in the foreign (non-U.S.) jurisdiction – in other words, in Canada. In June 2012, draft regulations changed the concept of substantial business activities to provide for a bright-line type of test. The test requires more than 25% of the assets, employees and income of the overall enterprise to be located in or derived from Canada. At first instance, this exception does not seem to be very promising since an income trust that carries on substantial business activities in Canada would be subject to the SIFT rules. However, if the issuer qualifies for the REIT exception in Canada, the SIFT rules would not apply. This combination of (a) the REIT exception from the Canadian SIFT rules for Canadian activities and (b) the substantial business activities exception from the U.S. inversion rules was used in the January 2013 initial public offering of Agellan Commercial REIT. Agellan is a Canadian income fund that acquired rental real properties in the United States and rental real properties in Canada. The Canadian operations were exempt from the SIFT rules under the REIT exception but were of sufficient scale to result in the satisfaction of the substantial business activities exception from the U.S. inversion rules. As a result, the U.S. owners could retain an interest in the operating business with typical rights to exchange the interest for units of the Canadian income trust and the right to receive distributions that were essentially identical to the distributions received by public holders of the income trust units. In this regard, the Agellan offering followed the path of the earlier HealthLease Properties REIT, which completed its initial public offering in June 2012.
In November 2012, Crius Energy Trust completed its public offering using a structure in which the rights of the retained interest holders were not equivalent to the rights of the public unitholders. The distribution rights of the securities, including their rights on liquidation, were determined not to be substantially similar to the distribution rights of the public holders of the income trust units. In particular, the retained interest holders had limited liquidity rights, which involved the right to have their interests acquired by the income fund in limited circumstances and at prices that were not directly referable to the public units or the trading price of the public units. As a result, the former U.S. owners were not considered to have an interest of over 80% in the CBIF for U.S. tax purposes. This remains to date the only offering in which a solution to inversion was found in the case of a diversified business (sale of energy contracts) outside the real estate area or the ownership of U.S. oil and gas assets (which we discussed last year). The Crius Energy trust involved the right circumstances in which such a solution could be found and involved tailoring the distribution rights to satisfy the conflicting requirements of the retained interest holders and the rights of the public holder of the income trust units. In general, however, there is no easy fix or cure for the U.S. inversion rules outside the real estate area. In certain circumstances, when solving for inversion was not possible, the approach taken has been to go public as a U.S. corporation that lists its shares on the TSX initially. An offering in Canada by a U.S. corporation will also require clearance by the U.S. Securities and Exchange Commission unless a suitable exception to such clearance exists, which provides a path to U.S. markets now or in the future.
It is in the area of U.S. real estate assets where CBIF activity flourished in 2012/2013. In addition to the Agellan structure described above, two other approaches of significance were used: one was first used in 2012, and the other was an innovation that appeared in early 2013. The older approach was taken in the initial public offering by Pure Multi-Family REIT LP in July 2012, and subsequent offerings similar to it, in which a Canadian publicly traded partnership acquired a U.S. corporation that qualified as a REIT for U.S. tax purposes (and the partnership was not a SIFT partnership because it owned only U.S. properties). The issuers in these offerings did not have former U.S. owners with a retained interest so inversion was not an issue. These structures resulted in a U.S. corporation that qualified as a U.S. REIT going public in Canada by means of a Canadian publicly traded partnership. This allowed the U.S. owners to capitalize on the advantages of quicker timing to market and the viability of a smaller offering size in Canada. Since a partnership is not a taxpayer for Canadian tax purposes (nor for U.S. tax purposes), this structure essentially results in the holders of the partnership units being taxed as though they directly owned the shares of the U.S. REIT owned by the partnership. The main advantage of being a U.S. REIT for U.S. tax purposes is that the U.S. REIT is not subject to U.S. entity level taxation provided that it distributes essentially all of its earnings to its securityholders so that the issue of U.S. tax leakage is solved in a straightforward manner. However, this structure does not provide a solution for the U.S. inversion issue, so may not apply if the U.S. owners have a retained interest.
A newer and novel approach that appeared in 2013 is the use of a Canadian income trust that itself also qualifies as a U.S. REIT. For this to work, it is necessary to cause inversion (to embrace inversion rather than avoiding it). The Canadian income trust owns only U.S. properties so it is outside the SIFT rules. Because it is inverted, it becomes a U.S. corporation for U.S. tax purposes and, therefore, the Canadian income trust can elect to be a U.S. REIT for U.S. tax purposes. Assuming that the Canadian income trust satisfies the technical requirements to qualify as a U.S. REIT, this means that (a) the Canadian income trust is not subject to U.S. tax, provided that it distributes essentially all of its earnings to its unitholders – this is the key feature of this structure, which eliminates the typical downside of being viewed as inverted; and (b) issues relating to the rights of the retained interest holders are solved since the U.S. former owners can hold an interest that is exchangeable for units of the Canadian income trust and is entitled to receive distributions that are essentially identical to distributions received by holders of the income trust units. Distributions paid by the Canadian income trust to Canadian unitholders are subject to U.S. withholding tax (other than for tax-exempt entities such as RRSPs), but the Canadian unitholders are generally entitled to a Canadian foreign tax credit for U.S. withholding tax. This approach was followed in the offerings by Milestone Apartments Real Estate Investment Trust in May 2013 and by WPT Industrial Real Estate Investment Trust in April 2013. We believe a number of additional proposed offerings, not yet public, intend to use this approach in 2013.
We note that a clone of the Dundee International REIT offering from 2011 also occurred within the last year involving international (and non-U.S.) properties. This was the offering in April 2013 of Inovalis Real Estate Investment Trust, a Canadian income trust that indirectly owns rental real properties in France and Germany. These types of structures are possible because the Canadian income trust does not own properties in Canada or carry on business in Canada. In addition, the U.S. inversion rules are not a problem since these international structures do not involve U.S. assets or businesses. The challenge in these types of international structures is to find ways to reduce local taxes, as well as withholding taxes, in the international jurisdiction, before the earnings find their way back to Canada and into the hands of the Canadian unitholders.
In summary, the last 12 months have shown a strong trend in the use of CBIFs, particularly in the cross-border REIT space, with interesting and novel approaches becoming commonplace. This trend shows every sign of continuing, as markets permit. In addition, the Crius Energy Trust offering has shown that it is even possible, in the right circumstances, to find a cure for inversion in the case of a diversified business.