Compensation issues and opportunities in real estate

Structuring tax-effective compensation programs for executives in the real estate industry can be challenging, particularly when the investment vehicle is a real estate investment trust (REIT). Certain unique considerations must be factored into the decision-making process when the employer is a REIT.

When the stock option provisions of the Income Tax Act were amended in 1998 to extend the favorable tax treatment of stock options to certain unit options, many REITs granted unit options to their senior employees. However, for the following reasons, unit options have not always met the expectations of executives:

1. Most REITs distribute a significant portion of their operating income to unitholders. Accordingly, the underlying units may not appreciate significantly in value between the time the options are granted and the time they are exercised.
2. During the period the unit options remain unexercised, the executive cannot receive the distributions made on the underlying units. Typically only a portion of the REIT distributions is taxable to the unitholder. Even if the executive is paid additional salary to replace the forgone distributions, executives have lost the favorable tax treatment afforded the distributions.

There are several methods for addressing the executives’ concerns while enhancing the efficiency of the compensation plan. In general, such methods involve ensuring that the executives receive units at a reduced tax cost. To ensure that the employer also benefits from these plans, performance criteria may be added to the vesting conditions.

Auxiliary unit grants
One alternative is to add additional units to the traditional grant. As cash distributions are made on the underlying trust units, the executive option holders will be granted additional options to acquire units at a nil or nominal exercise price. While 100% of the value of the benefit will be taxed as employment income when the option is exercised, the executive will still receive the underlying value of the units, thereby improving his or her economic position. In addition, the executive can control the timing of when he or she recognizes the benefit in income.

Restricted units
Another alternative is to grant the executive restricted units of the REIT. The units will be included in the executive’s income at the time they are acquired. However, the restrictions on the units, which will typically be linked to the timing of the executive’s ability to dispose of the units, will reduce the fair market value of the units. As a result, the executive will be taxed on a lesser amount.

As the restrictions lapse, the units will increase in value in direct proportion to the nature of the restrictions. However, this will not result in immediate taxation to the executive. Instead, the increase in value will only be taxed when the executive disposes of the units. At that time, the increase in the value will be effectively taxed as a capital gain, unless the personal circumstances of the executive dictate otherwise. In addition, the executive will receive all distributions following the acquisition of the restricted units. These distributions will retain their original characteristics and will not be taxed as employment income.

Executive loans
Another planning technique involves loaning the executive some or all of the funds needed to purchase the units on the open market. The interest rate can be set at a reduced rate, which would result in an employment benefit if the rate is less than the prescribed rate set by the government or the interest is not paid within a certain period. Any reported benefit will be treated as interest paid and will be deductible in the appropriate circumstances. The Canada Revenue Agency recently indicated in a technical interpretation that a portion of the interest on original money borrowed by a unitholder to acquire REIT units is not deductible to the extent that the unitholder receives a capital distribution from the REIT and uses such distribution for personal use.

The fair market value of the loan at the time of grant will not be included in the executive’s income, even if he or she is already a unitholder in the trust. The provisions of the Act, which dictate the terms of tax-effective loans to shareholders who happen to be employees, do not apply to unitholders. Thus, the loan can be structured as being forgivable in the event the units decline in value or the executives satisfy certain performance criteria. At the time the loan is forgiven, the amount forgiven will be included in income as an employment benefit. The cash flow required to pay the tax on the employment benefit is less than the funds that would have otherwise been required to repay the loan. However, if the loans are used to replace remuneration (such as a performance bonus) that the executives would have otherwise received, the loan may be characterized as a salary advance with the principal becoming taxable when the loan is advanced.

Determining which plan meets the needs of both the REIT and the executives involves a number of issues. The alternatives discussed here are not exhaustive. We have briefly described some of the concerns of executives. However, in formulating a comprehensive compensation strategy, it's important to also address the employer’s tax and accounting issues, as well as the concerns of other stakeholders.