Canadian pension funds are welcoming proposed regulations from the U.S. Department of the Treasury that clarify the sweeping exemption from U.S. tax on real estate available to qualified foreign pension funds.

“The previous regulatory framework reduced our demand for real estate in the U.S. and, as importantly, increased the cost and complexity of our structuring,” says Rob Douglas, managing director of the real estate investment group at the OPSEU Pension Trust. “In addition to increasing the desirability of U.S. real estate, [the proposed regulations] will hopefully decrease the tax structuring required for investments in the U.S.”

Read: Half of institutional investors plan to boost real estate holdings: survey

In December 2015, U.S. Congress enacted a section of the Internal Revenue Code of 1986, aiming to attract foreign capital to help refinance the country’s aging infrastructure and offering broad tax exemptions to foreign pension funds investing in U.S. real property.

“This was a dramatic economic event that effectively reduced the tax on U.S. real estate from 35 per cent to zero, effectively removing the tax penalty previously associated with U.S. real estate as compared to other asset classes,” says Paul Seraganian, a cross-border tax partner in Osler, Hoskin & Harcourt LLP’s New York office.

Of course, the desirability of investing in U.S. real estate soared. “The enactment . . . was a game-changer that had a double-barrelled impact of increasing the competitiveness of U.S. real estate, including certain infrastructure assets as compared to other private market assets and it increased the competitiveness of U.S. real estate compared to other international destinations,” says Douglas.

Read: CPPIB makes moves in global data centres, U.S. real estate

But the new regime also came with issues. “Not only were the margins of who was in and who was out unclear, but the parts that were clear were too rigid and restrictive,” says Seraganian. “Much of the difficulty arose because the legislation was drafted with an eye on the structure of U.S. pension funds, whereas non-U.S. funds come in all shapes and sizes.”

As an example, it was uncertain whether investment entities that managed pooled arrangements for pension funds, but didn’t have their own pension obligations, qualified for the preferential treatment. Historic legacy funds, which invest the various funds of merged companies through a master trust structure, were also offside. Those affected by these uncertainties included the Caisse de dépôt et placement du Québec, the British Columbia Investment Management Corp. and pension funds associated with bought-out companies such as Inco Ltd, which is now owned by Brazilian miner Vale Ltd.

The new proposed regulations do away with a great deal of the uncertainty by providing clarification in three key areas, namely the scope of the exemption itself, the requirements for meeting the criteria of a “qualified foreign pension fund” and the application of the code’s withholding tax rules to U.S. real estate investments. 

“The draft regulations provide much of the clarity we were looking for regarding what qualified as a qualified foreign pension fund,” says Douglas.

Read: BCI and partners creating Canadian real estate fund

Still, the proposals aren’t perfect. “Uncertainties remain around such matters as segregated accounts and de minimis ownership interests which need to be tested and better understood by all,” he adds. 

As well, the proposed  rules heighten the technical complexity of the overall regime and create new limitations. “Now is the time for Canadian pension funds to conduct a careful reassessment of their standing under the rules and identify any structural or organization modifications that may be appropriate,” says Seraganian. “Funds that find they have intractable issues under the new rules should consider making these issues known to Treasury before the regulations are finalized.”

The suggestions will probably be welcome. “Treasury has been bending over backwards throughout in setting out broader principles that will capture all the strange structures out there,” he adds. 

Read: Canadian pension funds increasingly using co-investments to diversity real estate holdings

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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