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Canada has proposed significant changes to its income tax rules that will result in certain Canadian income trusts and publicly traded partnerships being subject to an entity-level tax similar to the tax imposed on Canadian corporations. The Canadian income trust and real estate investment trust (REIT) market has expanded drastically in the last several years, and now there are more than 240 Canadian income trusts. These income trusts represent approximately 10% of the Toronto Stock Exchange and make up close to $200 billion in market capitalization. Canadian Association of Income Funds, Backgrounder: IncomeFunds, available at www.caif.ca/background. Many of these Canadian income trusts and partnerships own real estate and oil and gas properties. As a result of these proposed changes, U.S. REITs and certain oil and gas publicly traded partnerships will have a significant tax advantage over their Canadian counterparts. This article discusses how these entities are taxed in the United States and Canada and the potential effect of the proposed changes in the Canadian income tax rules. In general, under current law income earned by a Canadian income trust is taxed at the highest personal income tax rate. However, these publicly traded income trusts are entitled to a deduction in respect of their income for the year (including taxable capital gains) as the income becomes payable in the year to their investors. Therefore, if an income trust distributes all of its income to its investors, this income is taxed only at the investor level. If units of a Canadian income trust are held by a Canadian tax-exempt investor, then no income tax would be payable in respect of the underlying income. Similar to U.S. income tax rules, Canadian law does not consider a partnership a taxable entity. Instead, all income, gains and losses flow through to the partners, who then are taxed on their share of partnership income and gains according to the allocations set forth in the partnership agreement. As such, under current Canadian income tax law, income of a partnership is subject only to one level of taxation, and possibly no taxation when the partnership interests are held by Canadian tax-exempt investors. On Oct. 31, 2006, partly as an attempt to halt a trend of Canadian corporations converting to Canadian income trusts in order to achieve tax advantages, the Canadian government proposed a new income tax on certain publicly traded income trusts and partnerships. Under the proposed rules, certain types of income earned by certain Canadian income trusts and partnerships will be taxed in a manner similar to income by Canadian corporations. Specifically, the proposed tax rules will apply to “specified investment flow-throughs” (SIFTs). These are defined to include income trusts and certain partnership investments that are listed on a stock exchange or other public market; that are “resident” in Canada; and that hold one or more “non-portfolio properties.” Proposed sections 122.1 and 197 of the Income Tax Act (Canada). REITs are excluded from the above definition as long as they meet certain requirements relating to their investments and income that may severely limit the number of Canadian REITs excluded from these proposed rules. “Non-portfolio properties” include certain investments in a Canadian resident corporation, trust or partnership, or in Canadian resource properties, timber-resource properties and real properties located in Canada and other property that the trust or partnership uses in carrying on a business in Canada. In general, an investment in a Canadian resident corporation, trust or partnership is included when the income trust or partnership owns securities accounting for more than 10% of the equity value of such entity or if more than 50% of the equity value of the income trust or partnership is attributable to the securities held in such entity. Under the proposed rules, a Canadian income trust that is a SIFT will no longer be permitted to deduct certain amounts distributed out of its income from businesses carried on in Canada, or its income or capital gains with respect to nonportfolio properties. Instead, such amounts will be subject to Canadian income tax at a rate similar to that imposed on Canadian corporations, currently approximately 34%. Distributions from a Canadian income trust that is a SIFT, which are sourced from the trust’s nondeductible distributions, will be treated the same as a taxable dividend from a taxable Canadian corporation. Although this should not have a significant effect on Canadian taxable investors due to Canada’s partial tax integration system, such tax would do a significant harm to both Canadian and U.S. nontaxable investors. Similar rules apply in the case of a partnership that is a SIFT, rendering it taxable as a corporation in much the same way as certain U.S. publicly traded partnerships, with distributions recharacterized as dividends received by the partners. In general, if the securities of the SIFT begin public trading after October 2006, the proposed tax rules will apply as of Jan. 1, 2007. As a result, it now is unlikely that new income trusts will be established in Canada. For SIFTs that were trading before November 2006, the proposed tax rules will not apply until 2011. The Canadian government cautioned that any “undue expansion” of existing SIFTs may result in an adjustment to this transitional period, and has issued some guidance in this area based loosely on rules contained in regulations issued by the U.S. Treasury Department, defining an “existing partnership” for purposes of the publicly traded partnership transitional rules. Department of Finance (Canada) press release, Dec. 15, 2006. Also, the Canadian government said that modifications may be made to the proposed rules in the event that structures or transactions attempt to frustrate the rules’ objectives. Id. These rules have had a chilling effect on the valuation of Canadian income trusts and REITs and the number of additional initial public offerings or follow-on investments. The announcement of the proposed tax changes deflated trading prices for many income trusts. Tara Perkins, “REITs fear hit from income trust tax,” The Globe and Mail, March 5, 2007, available at www.theglobeandmail.com. As drafted, these rules do not appear to touch income deposit securities and certain cross-border trusts owning U.S. businesses. In the United States, a REIT is classified as a domestic corporation for tax purposes. Although its income is calculated in a manner similar to other taxable U.S. corporations, it is allowed a deduction for dividends paid to its shareholders. As long as the REIT satisfies certain requirements, the distribution of all of its income to its shareholders could result in no U.S. corporate-level taxation. Generally, in order to qualify as a REIT, a significant percentage of the REIT’s income must be passive income related to real estate activities. Similarly, most of its assets must be interests in real property, mortgages on real property and shares in other REITs. Special rules apply for hotels and other nontraditional real estate assets. In addition, a REIT is generally required to distribute at least 90% of its taxable income each year and is subject to corporate-level income tax on amounts that are not distributed. Currently, there are approximately 190 U.S. publicly traded REITs with a combined market capitalization of $400 billion. A U.S. publicly traded partnership (the interests of which are traded on a established securities market or readily traded on a secondary market) will be treated for U.S. income tax purposes as a corporation, and thus be subject to entity-level taxation, unless at least 90% of the partnership’s income is of a certain type of narrowly defined income (“qualifying income”). If the partnership has a sufficient amount of qualifying income, it will generally be treated as a partnership, and therefore its income will only be subject to taxation at the partner level. Several income sources qualify Qualifying income includes interest, dividends, real property rents, gain from the disposition of real property, income and gain from certain natural resource activities, gain from the disposition of a capital asset (e.g., selling stock) or certain property held for the production of income, as well as certain income and gains from commodities. Qualifying income from natural resource activities for this purpose is quite broad, including income from oil and gas, certain natural deposits, fertilizer, geothermal energy property and timber, as well as income or gain from the processing, transporting or marketing of any natural resource. Such qualifying income does not include income from fishing or farming, or from hydroelectric, solar, wind or nuclear power production. Currently, there are approximately 70 U.S. publicly traded partnerships, the majority of which are in energy related fields. National Association of Publicly Traded Partnerships, Current PTPs, available at www.naptp.org. The proposed tax changes applicable to Canadian income trusts and certain partnerships will deprive Canadian investors of their main source of high-yield investment. This will be exacerbated by the absence of a Canadian domestic high-yield debt market. The most profound effect will be on Canadian tax-exempt investors, which will have no tolerance for decreased yield resulting from these proposed changes. Given the diminished yield and the dearth of new Canadian issuances, they may need to look no further than to the U.S. REIT and publicly traded partnership markets (subject to limitations imposed on certain Canadian tax-exempt investors). Along with their success among Canadian investors, the Canadian income trust market has enjoyed an increased following among U.S. investors. In fact, in recent years, several energy trusts have been concerned about running afoul of certain Canadian ownership requirements. These rule changes may result in the flight of U.S. investors that have enjoyed higher yields from the Canadian income trusts. Unlike Canadian taxable investors, the underlying Canadian corporate income tax payable as a result of these proposed rules will not be able to be claimed as an effective credit at the unitholder level. Thus, double tax will apply, making these investments much less attractive. This yield-focused investor base may also find its way back into the U.S. REIT and publicly traded partnership markets, which are not burdened by an entity-level tax. Gary Gartner and Jeffrey Scheine are both partners in the tax department of Kaye Scholer’s New York headquarters. Gartner’s practice focuses on counseling clients on the U.S. and foreign tax consequences of transactions, restructurings and securities offerings. Scheine’s practice focuses primarily on Canadian investments in the United States. Kaye Sholer associate Michael Liptak in New York and Carrie Smit, a partner at Goodmans in Toronto, contributed to this article.

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