February 20, 2013

No. 2013-04



New REIT Rules — Welcome Improvements

Certain trusts may benefit from recent legislative changes to ease the requirements to qualify as a real estate investment trust (REIT) for income tax purposes. The proposed changes will not only ease the property and revenue restrictions of trusts that already qualify as REITs, but may also provide REIT status to trusts that did not qualify under the old rules (and were potentially subject to the tax applicable to specified investment flow-through (SIFT) entities). Some of these trusts may find that they are now able to qualify for the exemption from SIFT tax available to a properly organized REIT. 

The new tax rules are generally relieving in nature and have been well received by the Canadian REIT community. It is encouraging that the government has listened to the industry’s concerns and acted on them.

The new rules apply to 2011 and later taxation years but under a special elective provision, they may also apply retroactively to a post-2006 taxation year of a REIT if certain conditions are met. Although the bill that includes these new rules has received first reading and is considered substantively enacted for IFRS and ASPE, it is unclear how quickly the bill will make its way through Parliament and when it will be formally passed into law.

This TaxNewsFlash-Canada summarizes the new (and improved) rules as they are meant to apply when finally enacted into law.

Background — The new REIT rules

On October 24, 2012, Canada’s Department of Finance introduced proposed amendments to the Income Tax Act (Canada) to clarify the rules affecting REITs. These amendments provide even further improvements from the draft proposals released on December 16, 2010 (the 2010 proposals).


These amendments to the tax legislation affecting REITs (the new rules) were included in Bill C-48, the Technical Amendments Act, 2012, which received first reading in the House of Commons on November 21, 2012. 

 What is a REIT?

For Canadian income tax purposes, a trust is a REIT for a particular taxation year and therefore not subject to the SIFT tax if, throughout the year, it is resident in Canada and passes each of the following tests:

·      Property test

·      90% passive revenue test

·      75% real property revenue test

·      Qualifying property value test

·      Publicly traded test.

The publicly traded test, which requires that investments in the REIT be publicly listed or traded, was added under the new rules.

Property test

KPMG observations — Property test

Under the new rules, REITs now have a reasonable safe harbour for unintended issues resulting from the ownership of “bad” property and are allowed to conduct a degree of business activity that was not possible under the old rules. 


The new rules eliminate any technical concerns if a REIT holds substantial cash on deposit with a single financial institution (often, after a public offering or financing, or after a disposition of property).


The definition of eligible resale property has been amended from the 2010 proposals and now includes property that is contiguous to another eligible resale property. This change also allows the contiguous property to be held by an affiliate (not only a direct subsidiary of the REIT) and amends the requirement that the holding of such property be “ancillary” rather than “necessary and incidental to”. Property held for resale is by definition not held by “necessity”.


The new rules do not amend the definition of “real or immovable property”. As a result, for securities of a subsidiary entity to be “real or immovable property”, the subsidiary must comply with the original four REIT conditions and need not comply with new fifth condition (i.e., investments in the subsidiary entity need not be publicly listed or traded).

What is the property test?
The property test generally requires that the fair market value of all “non-portfolio properties” that are “qualified REIT properties” held by the trust is at least 90% of the total fair market value at that time of all non-portfolio properties held by the trust.

Previously, a REIT was not permitted to hold any non-portfolio property at any time during the year, other than qualified REIT property. The new rules amend the property test so that a REIT is now allowed to hold up to 10% of its non-portfolio property in assets that are not qualified REIT property. 

What is non-portfolio property?
“Non-portfolio property” generally includes:

·      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

·      Canadian real, immovable or resource property, if it, along with all of the entity’s Canadian real, immovable or resource property, represents more than 50% of the entity’s equity value

·      Property used in carrying on a business in Canada.

This definition has not changed in the new rules.

What is qualified REIT property?
“Qualified REIT property” generally includes:

·      Real or immovable property that is capital property, an “eligible resale property”, bankers’ acceptance of a Canadian corporation, money, or certain government debt or deposits with a credit union

·      Property ancillary to earning by the trust of rents and dispositions of real or immovable properties that are capital properties, other than an equity of an entity or a mortgage, hypothecary claim, mezzanine loan or similar obligation

·      Certain types of qualifying subsidiaries (generally, “property management subsidiaries” or “title nominees”).

Ancillary property
Unlike the 2010 proposals, ancillary property is not limited to tangible personal property. Therefore, intangible personal property that is ancillary to earning rent and realized gains from the dispositions of real or immovable properties that are capital properties (for example, tenant receivables or contractual entitlements) will continue to qualify. 

In determining whether property is ancillary to the earning of rent and realized gains from the dispositions of real or immovable properties, the new rules provide only for the specific exclusion of all equity and certain debt interests.

The definition of qualified REIT property has also been expanded under the new rules such that it includes the assets described in the qualifying property value test.

What is eligible resale property?
“Eligible resale property” was originally introduced under the 2010 proposals to allow the development of real property for resale in very limited circumstances. However, it was not included as qualified REIT property. The new rules clarify that eligible resale property is included as qualified REIT property.

Eligible resale property is real or immovable property of an entity that is:

·      Not capital property

·      Contiguous to a particular real or immovable property that is either capital property or eligible resale property of the entity or of an affiliated entity, and

·      Is ancillary to the holding of that particular real or immovable property or eligible resale property.

90% passive revenue test

The passive revenue test requires the REIT to derive not less than 90% (down from 95% under the old rules) of the trust’s “gross REIT revenue” for the taxation year from:

·      Rent from real or immovable properties

·      Interest

·      Dispositions of real or immovable properties that are capital properties

·      Dividends

·      Royalties

·      Dispositions of “eligible resale properties” (see definition above).

The inclusion of revenue from the disposition of eligible resale properties was originally introduced under the 2010 proposals.

Rent from real or immovable properties includes rent or similar payments for the use of, or right to use, real or immovable properties, and payments for services ancillary to the rental of real or immovable properties and customarily supplied by a landlord to its tenant.

KPMG observation — Revenue tests

The Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants observed that the definition of “rent from real or immovable properties” may not be sufficiently broad to capture common items received in respect of rent, such as lease termination fees or receipt of damages for unpaid rent. However, such amounts may be payments similar to rent.

75% real property revenue test

The real property revenue test requires that not less than 75% of the trust’s gross REIT revenue for the taxation year be derived from:

·      Rent from real or immovable properties

·      Interest from mortgages, or hypothecs, on real or immovable properties

·      Dispositions of real or immovable properties that are capital properties.

Although dispositions of eligible resale properties are now qualifying revenue under the passive revenue test, such amounts are not qualifying revenue under the real property revenue test.

The new rules do not make any significant changes to the real property revenue test.

What is gross REIT revenue?

The new rules clarify that both the passive revenue test and the real property revenue test are based on “gross REIT revenue”, which is defined as the amount by which the total of all amounts received or receivable in the year by the trust exceed the cost to the entity of properties disposed of in the year.

KPMG observations — Gross REIT revenue

Gross REIT revenue arising on the disposition of real or immovable properties only includes the portion of amounts received or receivable that exceeds the cost of the property. Accordingly, recaptured depreciation is not included in gross REIT revenue. In addition, certain benefits deemed to be included in the income of a taxpayer are not included in gross REIT revenue unless such amount is deemed to be received by the taxpayer. 


Losses sustained by a REIT on the disposition of its real property that is capital property or its eligible resale property are not included in gross REIT revenue. Consistently, such losses are not included in the REIT’s passive revenue test or real property revenue test and therefore do not affect a REIT’s ability to meet its revenue tests.


Selling costs relating to the disposition of real or immovable property do not reduce gross REIT revenue.

Flow-through of revenue characterization
The new rules clarify that, for purposes of determining gross REIT revenue of a trust, amounts received or receivable from certain entities that have a particular character will retain that character when included in the gross REIT revenue of the trust. These character preservation rules apply to amounts from a source entity, if at any time in the taxation year, the trust:

·      Is affiliated with that entity, or

·      Holds securities of the source entity (namely, shares if the entity is a corporation, an income or capital interest if that entity is a trust, or a partnership interest if the entity is a partnership) that have a total fair market value that is greater than 10% of the source entity.

These character preservation rules apply to the revenue received or receivable by a REIT from qualifying subsidiaries unless that revenue can reasonably be considered to be derived from certain property management revenue (i.e., revenue from maintaining, improving, leasing or managing real or immovable properties that are capital properties of the REIT, or an entity in which the trust holds a share or interest).

The explanatory notes accompanying the new rules state that these character preservation rules are intended to work iteratively through a chain of ownership of several levels of subject entities.

KPMG observations — Revenue character preservation

The scope of the revenue character preservation rules are limited to circumstances in which the REIT has a sufficient equity investment in the source entity. Therefore, for example, this prevents the recharacterization of interest received by a REIT on a loan to an entity in which it does not have a significant equity interest.


The exclusion of the REIT’s internal property management revenue from the character preservation rules is helpful. For example, a dividend received by a REIT from its property management subsidiary corporation would retain its character as a dividend, which is qualifying revenue under the passive revenue test.


Illustration of Revenue Character Preservation


In the common example of a REIT with both Canadian and U.S. rental properties, as shown above, a U.S. subsidiary corporation (US Sub) pays a dividend out of its U.S.-source net rental income to its Canadian parent corporation (Canco), which in turn pays a dividend to its Canadian REIT parent (REIT). The taxable dividend received by the REIT would be deemed to be rent from real or immovable properties. Such deemed amount is therefore qualifying revenue for both the passive revenue test and the real property revenue test. Under the old rules, the dividend would not have been qualifying revenue under the real property revenue test.


Similarly, interest received by the REIT on loans to US Sub (incurred for the purpose of earning revenue from real or immovable property) would be deemed to be rent from real or immovable properties and therefore qualifying revenue for both the passive revenue test and the real property revenue test. Under the old rules, the interest would not have been qualifying revenue under the real property revenue test (unless the loans were structured as mortgages or hypothecs on real or immovable properties).


If US Sub earns income from multiple sources, it is necessary to trace the source of activity from which the payment of interest or dividends was derived.


The interplay of the revenue character preservation rules and the treatment of partnerships remain unclear. For this purpose, amounts received or receivable (interest or distributions) on debts or equity of a partnership are not specifically excluded. Administratively, under the old rules, the CRA confirmed in a technical interpretation issued in 2010 that each partner of a partnership is considered to earn its portion of the partnership’s revenue for purposes of the passive revenue test and the real property revenue test.

REITs holding foreign real or immovable property may finance the acquisition of such property using debt denominated in a foreign currency. Also, given the potential foreign currency risk in holding foreign assets, REITs may choose to enter arrangements that hedge that risk.

The new rules deem certain amounts included in gross REIT revenue to have the same character as gross REIT revenue in respect of the underlying real or immovable property that result from:

·      Interest-rate hedges entered into by the REIT in respect of debt incurred by the REIT to acquire or re-finance real or immovable property, and

·      Foreign currency gains in respect of real or immovable property situated in a country other than Canada recognized on:

(i)              revenue of such non-Canadian real or immovable property

(ii)             debt incurred by the trust for the purpose of earning such non-Canadian revenue, or

(iii)            foreign currency hedges.

KPMG observations — Hedging transactions

A loss sustained on a hedging transaction is not an amount received or receivable and is therefore not relevant in the computation of gross REIT revenue. 


For an interest-rate hedge or a foreign currency hedge on debt, the revenue characterization rules do not appear to apply if the hedge is entered into by an entity other than the entity which incurred the debt. However, this limitation does not seem to apply to a foreign currency cash flow hedge on a REIT’s direct or indirect non-Canadian real property rental revenue.

Qualifying property value test

Under the qualifying property value test, at least 75% of the trust’s “equity value” throughout the taxation year must be comprised of the total fair market value of a trust’s real or immovable property, bankers’ acceptance of a Canadian corporation, money, or certain government debt or deposits with a credit union. 

For taxation years ending after 2012, the new rules require that the real or immovable property for purposes of this test must be either capital property or eligible resale property.

New rules’ retroactive application

The new rules apply to the 2011 and subsequent taxation years. The new rules may also apply to a taxation year of a REIT ending after 2006 if the investments in the REIT are listed or traded in that earlier year and the REIT elects in writing on or before its filing due-date for its taxation year that includes the day on which the new rules receive Royal Assent.

The ability to elect to have these rules apply retroactively may benefit a REIT that was not eligible for the grandfathered exemption from the SIFT tax (for example, a REIT that became publicly traded after October 31, 2006 or a REIT that exceeded its normal growth guideline).

A REIT is not always a REIT

A properly structured trust that holds only non-Canadian real or immovable properties is not a SIFT trust and does not have to meet the REIT conditions.

KPMG observations — Structural and activity issues

Although the new rules address most of the concerns raised by members of the real estate industry, the following technical issues and tax policy restrictions should be considered:

Depreciable property
Depreciable property that is not Class 1 (for example, Class 17, paving) must still be ancillary to the ownership or utilization of a building in order to be qualified REIT property. In other words, a paved parking lot that generates income from a parking lot operation must also support a building. However, the expanded 10% safe harbour under the property test likely alleviates any practical concerns in this regard.

Excluded subsidiary entities
Many REITs hold real estate in subsidiary partnerships, often with outside investors. Such subsidiary partnerships are exempt from the SIFT tax regime if they are structured as excluded subsidiary entities. This exclusion requires that the equity of the entity is not publicly listed or traded and held at all times by certain qualifying interest holders. 

Proposed legislation expands the list of qualifying interest holders to include persons (including individuals, trusts, tax-exempt entities, or non-residents) that do not have a right, in connection with the holding of such interest, to property the value of which is determined by reference to a publicly traded security.

Therefore, a REIT’s subsidiary partnership may still be a SIFT partnership and subject to SIFT tax if an individual holds an interest in the partnership that is exchangeable into the REIT’s publicly traded units.

SIFT partnerships
A SIFT partnership cannot qualify as a REIT. A publicly listed vehicle to hold Canadian real property must be structured as a trust in order to meet the REIT exemption.

Mortgage lending
Mortgage lending or mezzanine financing is a common means of acquiring new real property in the real estate industry. While the new rules would still restrict qualifying REITs from conducting extensive mortgage lending, a limited degree of such activity may be possible. For example, where loans are secured by mortgages on real property and the loans (along with all other non-portfolio property that is not qualified REIT property) represent less than 10% of the fair market value of all non-portfolio property held by the REIT.

Hotels and seniors’ housing
The hotel and seniors’ housing sectors are not able to qualify as REITs unless the non-qualifying assets and revenues of such businesses represent less than 10% of their total assets and revenues. The U.S. REIT regime allows REITs to conduct non-qualifying activities through taxable REIT subsidiaries. Members of the Canadian real estate industry have asked Finance to consider this approach, with appropriate thin capitalization limitations and requirements to transact with related parties at fair market value to ensure that such subsidiaries pay appropriate amounts of tax.

KPMG observations — Accounting implications

For purposes of Accounting Standards for Private Enterprises (ASPE) and International Financial Reporting Standards (IFRS), when there is a majority government, tax changes are considered to be “substantively enacted” when a tax bill containing the detailed legislation is tabled for first reading in the House of Commons or the provincial legislature. 


Accordingly, with Canada’s current majority Conservative government, the impact of the new rules (if any) is reflected in an entity’s financial statements for reporting periods ending on or after November 21, 2012 prepared under ASPE or IFRS. 


For U.S. GAAP purposes, however, tax changes are considered enacted once the relevant bill has received Royal Assent. As of the date of writing and for purposes of 2012 calendar year financial reporting, the new rules have not received Royal Assent and are therefore not yet enacted for purposes of U.S. GAAP.

We can help

KPMG's Building, Construction & Real Estate Practice has more than 300 professionals dedicated to serving the real estate needs of our clients. We operate nationally as a fully integrated business unit so that all of our multi-functional skill sets and experience is available to our clients.

We provide a wide range of independent reporting, tax, valuation and corporate finance advisory services to participants in the Canadian real estate industry, including REITs, pension funds, investment funds, private investors, banks and life insurance companies, private developers and corporate landlords and tenants of real estate.

Our multi-disciplinary team with the combined skills of chartered accountants, valuators, MBAs and bankers is dedicated to serving our clients' real estate needs. We work closely with our real estate colleagues worldwide to apply specific accounting, tax, advisory and consulting expertise to assist our clients in today's challenging real estate market.

For details, please contact your KPMG adviser or one of the following:

Lorne Shillinger (National Leader of KPMG’s Real Estate Taxation practice) at 416-777-8692

Walter Pela (Vancouver) at 604-691-3193

Antony Schiefer (Toronto) at 416-777-8361

Bill Lau (Vancouver) at 604-691-3502

Jon Newton (Toronto) at 416-777-3714

Bronche Cheng (Vancouver) at 604-646-6365

Shawn Stern (Toronto) at 416-777-8831

Tony Tse (Vancouver) at 604-691-3078

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Information is current to February 19, 2013. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.


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