Advocates for the Canadian commercial real estate industry are asking the federal finance department to clarify why real estate investment trusts (REITs) have been included in a pending new tax measure. The 2 per cent tax on the repurchase of equity — also known as share buybacks — was first announced in the government’s fall economic statement last November with the promise of more details in the 2023-24 budget. Those elicited some surprise when they were released two weeks ago.

“We were not expecting it to apply to REITs. It makes little sense when REITs are required to distribute all their taxable income,” says Michael Brooks, chief executive officer of REALPAC, which counts REITs among its wider membership of prominent commercial real estate companies, property funds and investment managers. “Mutual fund trusts are exempted, which also makes the reasoning for the application to REITs murky.”

The tax has been framed as a similar measure to a new 1 per cent tax on the repurchase of equity that came into force in the United States in January 2023, but REITs are explicitly exempted from the U.S. levy. It’s generally assumed that’s in recognition of the structural differences between REITs and other types of publicly traded companies that issue dividend stocks.

For the latter, share buybacks could be a means to distribute excess cash with more favourable tax consequences for shareholders than if it was paid out as dividends since investors would be taxed on capital gains rather than on earnings on investment. However, the tax rules governing REITs already preclude that option. REITs are afforded a corporate tax exemption but, in turn, are required to pay out 85 to 100 per cent of their taxable income to investors through monthly distributions.

The resulting product offers a wide range of investors, including individuals and pension funds, indirect ownership of real estate assets with the benefit of professional management, along with the potential for higher dividends than they might earn from a comparable investment in dividend stocks. Erkan Yonder, an associate professor with the Jonathan Wener Centre for Real Estate and chair of the finance department at Concordia University’s John Molson School of Business, notes that REITs enjoy this special tax arrangement in 44 countries around the world, and suggests a tax on repurchasing equity would be something of an incursion on that status in Canada.

“Real estate is a capital-intensive investment so if REITs lose their tax benefit, this can create a wave of privatization,” he says. “Public REITs are very important to add transparency to the real estate markets.”

Oil and gas corporations thought to be Canadian government’s main concern

The budget document outlining Canada’s proposed new tax measures states that REITs, specified investment flow-through (SIFT) trusts and SIFT partnerships have been included “to ensure comparable treatment among different types of publicly traded businesses”.

As proposed, Canadian-resident companies that trade shares or units on Canadian exchanges would be subject to a 2 per cent tax on the net annual value of equity they repurchase through normal course or substantial issuer bids. There would be three general exceptions for: repurchasing debt-like preferred equity; share/unit buybacks related to specified corporate reorganizations and acquisitions; or a volume of buybacks totalling less than $1 million for the taxation year.

The budget estimates the tax should garner $2.475 billion between Jan. 1, 2024, when it is scheduled to take effect, and the end of the 2027-28 fiscal year. It also asserts: “Importantly, this would also encourage firms to reinvest in their workers and businesses.”

That is likewise a rationale for the U.S. tax, which was introduced as part of the multi-faceted Inflation Reduction Act (IRA). In part, the measure is aimed at encouraging companies to reinvest their profits in the various avenues for reducing greenhouse gas (GHG) emissions that the IRA enables.

Analysis from the U.S. Congressional Research Service charts the growing use of share buybacks and a particular uptick after the country’s tax laws were revised in 2018. This now far outdistances dividends as a mechanism for returning profits to shareholders with the total value of share buybacks pegged around USD $1 trillion in 2022 versus the USD $550 billion dispersed in dividends. Critics of the practice argue that it diverts reinvestment, spurs debt financing that can have longer-term destabilizing effects and disproportionately rewards major shareholders since taking shares off the market should push up the value of the remainder.

While tech and digital communications firms like Apple, Meta Platforms, Alphabet, Microsoft and Oracle are identified as the leading repurchasers of stock in the U.S., analysis from the accounting and tax services firm, Andersen, hypothesizes that the Canadian government may be more focused on public oil and gas corporations — noting that they “have been especially criticized for making record profits and issuing share buybacks instead of reinvesting their excess capital in clean energy”.

Yonder advises REIT managers are most likely to repurchase equity when they judge the market value of their stock to be out of sync with the value of their underlying real estate assets. That dissonance has been notable recently as investors ponder rising interest rates and the fallout of the COVID-19 pandemic in the office sector.

“REIT stock prices are more subject to misvaluation currently due to these uncertainties,” Yonder maintains. “Earnings management is less of an issue for REITs than other corporations, and stock repurchases are more tools for (addressing) undervalued stock. Taxing REIT repurchases makes things more complicated for REIT managers.”

“We will be following up with the federal department of finance to clarify and possibly seek an exemption,” Brooks affirms.

Barbara Carss is editor-in-chief of Canadian Property Management.