Menu
Tax Notes logo

Canada's Pension Investment Board Comments on Guidance on Distributions Between Foreign Governments, REITs

OCT. 28, 2008

Canada's Pension Investment Board Comments on Guidance on Distributions Between Foreign Governments, REITs

DATED OCT. 28, 2008
DOCUMENT ATTRIBUTES

 

October 28, 2008

 

 

Mr. John L. Harrington

 

International Tax Counsel

 

U.S. Treasury Department

 

1500 Pennsylvannia Ave N.W.

 

Washington, D.C. 20220

 

 

Dear Mr. Harrington:

On behalf of the Canada Pension Plan Investment Board ("CPPIB"), I wish to thank you for taking time to meet with my colleague Babak Abbaszadeh and me, and with our counsel, on September 24, 2008 to discuss a series of tax policy issues that are of interest to CPPIB in connection with its ongoing program of investments in the United States. In this letter, I would like to highlight several of the points we made during the course of our meeting.

As we discussed, CPPIB was created by an Act of the Parliament of Canada in 1997 as an independent entity to invest and maximize the return on assets of the Canada Pension Plan ("Plan") without undue risk of loss. The Plan is a mandatory contributory defined benefit pension plan and is operated for the benefit of 17 million Canadians. CPPIB operates with extremely high levels of disclosure and transparency.

In order to sustain and grow the Canada Pension Plan Fund ("Fund"), CPPIB needs to invest globally in all major asset classes such as public and private equities, fixed income instruments, inflation-linked bonds, infrastructure and real estate. At present, almost half of CPPIB's non-Canadian investments are in the United States and encompass each of these broad asset classes. Given CPPIB's investment mandate and the fiduciary nature of its mission, CPPIB must take into account the taxation requirements of the jurisdictions in which investments are made. As a result, CPPIB has a keen interest in the scope of the U.S. tax exemption provided for foreign governments under section 892 of the U.S. Internal Revenue Code. Therefore, we requested our meeting with you in order to:

 

1. Make sure we understand the policy considerations that underpin the tax rules we discussed; and

2. Acquaint you and your colleagues with the impact of those policies on our own future investment decisions.

 

In particular, this letter summarizes the views we expressed in our meeting regarding Notice 2007-55. The letter also documents our concern with the section 892 limitation on commercial activity generally, including as it relates to investments in distressed debt and derivative financial instruments.

Notice 2007-55

CPPIB has significant investments in U.S. real estate, which have principally been made through U.S. real estate managers and funds, including investments in U.S. controlled and managed real estate investment trusts (REITs). While CPPIB's statutory investment objectives controlled the decision to make these investments, they have generated income for and bolstered the growth of these U.S. funds, supported the U.S. real estate market, and provided liquidity for the U.S. economy.

The position taken by the Internal Revenue Service ("IRS") in Notice 2007-55 (the "Notice") with respect to the application of section 892 to capital gain distributions, including liquidating distributions, by REITs has engendered debate among tax professionals about its correctness as a matter of law. CPPIB has been advised that there is no statutory provision that compels the position taken by the IRS with respect to section 892 in the Notice and, further, that the IRS position was based on broader policy considerations. As such, our meeting focused in large part on providing additional information to assist you and your colleagues in assessing all relevant policy implications. If the position taken in the Notice with respect to section 892 is not changed, CPPIB will be required to make its future investment decisions on the basis that its passive and minority positions in the stock of U.S.-controlled REITs will have a substantially lower after-tax return.

There are many factors, of which tax is only one, relevant to an investment decision. But there is no question that investments yielding substantially lower after-tax returns are less attractive. Thus the implementation of the strict application of the interpretation of section 892 contained in the Notice will result in less foreign investment in U.S. real estate funds structured as REITs. That could well be true in the case of future investments by CPPIB. Given its statutory investment mandate to maximize return on the assets in the Fund, CPPIB is obligated to seek the most attractive investments. Consequently, CPPIB hopes that, in making the final determination whether to implement the narrow interpretation of section 892 contained in the Notice in the forthcoming regulatory proposals, all relevant policy considerations and potential economic effects will be taken into account.

Commercial Activity Limitation

At our meeting, we also discussed two issues related to the scope of the "commercial activity" limitation contained in section 892. The scope of this limitation is critically important to CPPIB, since the manner in which section 892 applies to CPPIB means that any commercial activity, however modest, will jeopardize the availability of the section 892 exemption for all other income, including non-commercial income such as dividends on stock.

The first area of concern relates to investments in portfolios of debt instruments that are or may become non-performing, an issue that has particular relevance given current economic conditions. We understand the concern has been expressed that "work out" activities undertaken following the purchase of these kinds of debt instruments may disqualify these investments as passive investments for foreign non-governmental investors and be treated as a "trade or business" activity instead. As you are aware, requests for appropriate clarifications to address the concerns of foreign non-governmental investors have been submitted to the Department of the Treasury and the IRS. Even if such guidance is issued, it will not necessarily resolve uncertainties faced by foreign governmental investors, because the "commercial activity" standard contained in section 892 encompasses activities that do not rise to the level of a "trade or business". CPPIB believes that it would be desirable for any guidance that is issued in this area to address issues relevant to foreign governmental investors as well as foreign non-governmental investors. More broadly, if the Department of the Treasury issues guidance regarding lending activities of foreign persons under section 864 -- whether such guidance addresses solely distressed debt or whether it encompasses broader issues such as loan origination -- then it would be helpful if comparable guidance for foreign governments were issued under section 892.

Secondly, CPPIB understands that consideration may be given to possible revisions to the section 892 regulations. These regulations have not been revised significantly since 1988, and CPPIB supports modernizing the regulations to reflect the current practices of many large institutional investors. Specifically, CPPIB believes that the regulations should be revised to provide that an investment in a derivative financial instrument, whether traded on an exchange or over the counter, will not be treated as commercial activity when it is made for an investment purpose (rather than solely for the purpose of executing governmental financial or monetary policy). Modernizing the regulation in this way would create parity between foreign governmental investors and foreign non-governmental investors, who are permitted to rely on a substantially similar proposed safe harbor for trading in derivative financial instruments. Importantly, this action would not extend the section 892 exemption to the income from investments in derivative financial instruments. Whether the income earned by such an investment would be subject to U.S. tax would be determined under the rules applicable to most other foreign investors. However, a modernized regulation would eliminate the risk faced by organizations such as CPPIB that a single passive investment of this kind could jeopardize the exemption for other income that clearly falls within the scope of section 892.

 

* * *

 

 

Once again, I thank you for taking time to meet with us. Should you have any questions, please do not hesitate to contact my colleague, Babak Abbaszadeh, Director, Stakeholder Relations, CPPIB at 416-868-6612 (or by email: Babak@cppib.ca). We stand ready to respond to any questions you may have.
Very truly yours,

 

 

Benita Warmbold

 

Senior Vice-President and

 

Chief Operations Officer

 

cc:

 

Assistant Secretary Eric Solomon, U.S. Treasury Department

 

Commissioner Douglas Shulman, U.S. Internal Revenue Service

 

Donald Korb Esq, Chief Counsel of the U.S. Internal Revenue Service

 

Mr. Robert Spindler, VP and Head of Tax Services, CPPIB
DOCUMENT ATTRIBUTES
Copy RID