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JULY/AUG 2021

Interest Deductibility Limitation back under active consideration By John Dickie, CFAA President

Eighteen months ago, CFAA’s representations (and COVID-19) turned back a federal proposal to impose an interest deductibility limitation (IDL) for the computation of taxable income –-fixed at 30% of net operating income for all businesses. However, the issue has arisen again in the 2021 Federal Budget. The proposed interest deductibility limitation (IDL) would artificially inflate taxable income on rental properties by disallowing some of the actual costs incurred. That will result in the imposition of taxes on income which owners do not actually receive. See Tables 1 and 2 on pages 37 and 38 for samples of the effect of an IDL on rental housing providers.

What the 30% limit will apply to Technically, the 30% interest limitation test will apply to earnings before interest, taxes, depreciation and amortization (EBITA). That is close to net operating income. For a transition year, the limitation is to be 40%. One year is far too short a transition period, given the length of time for which rental housing providers have mortgage and loan commitments. There is to be an exemption for businesses with taxable capital of less than $15 million dollars, but taxable capital includes loans; and so, an owner could have that much taxable capital while only having equity of $2M or $3M or less.

If an IDL goes forward now, that would be a problem for many rental housing providers, since rental housing is capital intensive. An IDL would be a very serious problem for highly leveraged rental providers or developers. The issue could affect many more rental housing providers when interest rates rise, which is bound to happen at some time. CFAA is advocating an exemption for all real estate businesses, including rental housing. Our best policy argument is that Canada needs more rental housing, and governments want to encourage a larger supply of rental housing, whereas an IDL would have the exact opposite effect on rental supply.

Why do rental housing providers have high interest costs? Rental owners certainly provide on-going services like cleaning and repairs, and pay utilities and insurance, but the bulk of what rental owners provide is the use of a suite in a building. That has been paid for by equity and borrowing, and most buildings are still encumbered with substantial mortgages on which substantial interest is paid. As mortgages are paid down over time, mortgage financing is typically increased to pay for major repairs and renovations, including energy and other building upgrades. Most rental owners finance their properties to 40, 50 or 60% of value on an on-going basis. Many rental housing providers finance new construction or acquisitions at a higher rate than that, often at 80 or 90%. To encourage rental development, CMHC insures mortgages on new construction at up to 90% of property value. As a result, many rental owners pay between 30% and 50% of EBITDA in interest payments! The IDL plan was triggered by work done by the Organization for Economic Cooperation and Development. That is an organization of 38 member countries, including Canada, the US, Australia, Japan and most European countries, which seeks “to build better policies for better lives”.The OECD pays considerable attention to government policies. Many developed countries have become concerned about international corporations, or corporate groups, shifting taxable

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NATIONAL OUTLOOK income to low-tax jurisdictions. To prevent that being done by inter-group loan allocation, the OECD has called on all countries to impose an IDL of not more than 30% to prevent “base erosion and tax shifting” (BETS). (The US took a different tack on BETS by calling for all countries to adopt minimum corporate tax rates.) However, there are only a limited number of rental housing providers in Canda which borrow abroad, or which operate as part of an international corporate group. In borrowing within Canada, the interest payments are subject to Canada’s tax laws, and thus are generally subject to tax as income in Canada. Not being part of an international corporate group means there is no opportunity for base erosion or tax shifting. As well, Canada and the US have similar rental housing sectors, which are very different from those in the rest of the OECD. Only the US and Canada have any significant presence of large-scale corporate developers creating and holding large portfolios of multi-unit residential properties. The US government has effectively exempted all real estate businesses from its IDL rule, which is section 163(j) of the US Tax Code.

Conclusion There is no base erosion or tax shifting problem in rental housing to solve, but imposing an IDL would create a major problem for the rental housing industry, and run counter to other important government policies which seek to increase rental housing supply and facilitate the financing of energy saving and other building retrofits. The Government of Canada should exempt all real estate businesses and partnerships from any interest deductibility limitation.

Impact of a 30% interest deductibility limitation on rental housing providers

Table 1 shows two typical situations for a rental building which has been held for five or ten years: first, a typical income, expense and tax situation for a principal business corporation (a PBC), and second, the situation for a real estate investment company, with five or fewer full-time employees. All the figures are based on one unit in a multi-unit building. Both situations assume a 50 per cent borrowing ratio (loan-tovalue), and a 3.25 per cent interest rate. (That rate would be high for a CMHC-insured mortgage today, but it is not high by historical standards, when much current debt was taken on.) Table 1: Typical income, expense and tax situations with low leverage Section

Building item (per rental unit)

Basic building facts

Current tax situation Apparent proposal

Comparison

Principal Business Corp (PBC)

Real Estate Investment Corp

Property value

$180,000

$180,000

Gross rental income

$12,000

$12,000

NOI (= EBITDA)

$7,200

$7,200

Interest payments per year

$2,925

$2,925

Capital cost allowance claimed

$2,000

$2,000

Net income before tax

$2,275

$2,275

$830

$1,140

Total corporate tax (fed & prov - approx) Net income after tax

$1,445

$1,135

Interest payment allowed (30% of NOI)

$2,160

$2,160

Notional net income for tax calculation

$3,040

$3,040

Total corporate taxes (fed & prov - approx)

$1,110

$1,525

Actual net income (from above)

$2,275

$2,275

Actual net income after tax

$1,165

$750

$279

$380

33.5%

33.5%

Increase in tax (in dollars) Increase in tax (as percentage)

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JULY/AUG 2021 Notes (applicable to both tables) 1. Net operating income is a real estate term, which is similar to EBITDA. Therefore, using NOI based on rents for the calculations is a close approximation of EBITDA. 2. Provincial taxes on corporations vary slightly. Some are slightly above Ontario’s, and some are slightly below Ontario’s. Ontario’s is used in the table. Table 2 shows two typical situations for a rental building which has been acquired recently and given major repairs or renovations: first, a typical income, expense and tax situation for a principal business corporation (a PBC), and second, the situation for a real estate investment company, with five or fewer full-time employees. All the figures are based on one unit in a multi-unit building. Both situations assume an 80 per cent borrowing ratio (loan-to-value) and a 3.25 per cent interest rate. (That rate would be high for a CMHC-Insured mortgage on property today, but it is not high by historical standards, when much current debt was taken on.) Table 2: Typical income, expense and tax situations with high leverage Section

Building item (per rental unit)

Basic building facts

Current tax situation

Principal Business Corp (PBC)

Real Estate Investment Corp

Property value

$180,000

$180,000

Gross rental income

$12,000

$12,000

NOI (approx. = EBITDA)

$7,200

$7,200

Interest payments per year

$4,680

$4,680

Capital cost allowance claimed

$2,000

$2,000

Net income before tax

$520

$520

Total corporate tax (fed & prov)

$190

$2600

Net income after tax Apparent proposal

$330

$260

Interest payment allowed (30% of NOI)

$4,680

$4,680

Notional net income for tax calculation

$3,040

$3,040

Total corporate taxes (fed & prov - approx)

$1,110

$1,520

Actual net income (from above)

$520

$520

($590)

($1,000)

$920

$1,260

485% approx. 5 times

485% approx. 5 times

Actual net income after tax (loss) Comparison

Increase in tax (in dollars) Increase in tax (as percentage), and a multiple

A new 30% limit on interest deductibility for Canadian corporations, REITs or partnerships would dramatically increase income taxes on rental housing, taxing notional income which owners do not actually receive, and forcing some rental housing providers into a loss position.

GHG reductions and the cost of heating rental buildings

Energy issues are coming to the forefront of public policy, with suggestions that homeowners and rental housing providers be forced to reduce greenhouse gas (GHG) emissions by changing from heating buildings with oil or natural gas, to heating with electricity instead. That is called “de-carbonization” or “de-gasification”. In most areas, that change would reduce greenhouse gas emissions, but it would result in major retrofit costs which would be borne by both rental housing providers and renters, unless government subsidizes those costs. CFAA is ramping up our efforts to minimize the negative impact of energy moves at the federal level, including seeking to increase access to beneficial programs and incentives for rental housing providers. Provincial and municipal policies and rules are generally issues for the various provincial and regional associations, but CFAA seeks to facilitate information exchange on such nation-wide issues, for the benefit of rental housing providers across Canada.

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NATIONAL OUTLOOK Examples - across Canada and abroad As one example of the possible public policy moves, the City of Ottawa has adopted a Climate Change Master Plan. Part of that plan is the “Energy Evolution” action plan for how Ottawa will meet its target to reduce greenhouse gas emissions to zero by 2040 or 2050. The City of Toronto has adopted a similar plan, known as Transform TO, while Vancouver has adopted its own Climate Emergency Action Plan, and other cities across Canada are considering similar plans. The U.K. is banning gas boilers in new homes from 2025. Cities in the states of California, Washington and Massachusetts are also trying to phase out the use of natural gas. Some Canadian provinces are working with the federal government on a Retrofit Building Code, which would require energy upgrades to existing buildings. In BC, Manitoba, Ontario and Quebec, where the provincial power grids do not produce a lot of GHG emissions, fossil fuel combustion to heat buildings represents a major source of GHG emissions. Buildings heated with fossil fuels can cut some of their emissions by reducing the need for heating through actions like better insulation and reusing “waste” heat. But in order to make a big difference, the green building industry and governments are looking to electrify heating. The City of Vancouver is trying to come up with regulations and incentives for homeowners to electrify their home heating. Those or similar regulations may be applied to rental housing too.

Heating technologies Currently in Canada, the most common way of using electricity for heating is through baseboard heaters. They are powered by electrical resistance heating, just like a toaster or an oven. Electric forced-air furnaces, electric convection heaters and electric radiant floors also use electrical resistance heating. Baseboard heaters are popular because they are very cheap to buy and easy to install. However, those and other kinds of electrical resistance heaters result in high electricity bills. Obviously, if the landlord pays for the electricity, high electricity costs are undesirable. Even if the electricity is paid by a tenant directly to the utility company, an inefficient heating system is undesirable because such a system makes the total cost of the tenant’s housing higher, which reduces the rent which the tenant is willing to pay to their landlord. Heat pumps are generally a more efficient electrical heating method because they move heat into homes, rather than generating heat. There are two kinds: •  Air source heat pumps, which draw heat from the air, and •  Ground source heat pumps, which draw heat from the ground. Ground source heat pumps are sometimes referred to as geo-exchange or geothermal heat pumps. They have a high capital cost since pipes need to be placed underground. They also need land under which to place the pipes; and so, they may not be feasible in dense urban settings, where many rental buildings are located. Heat pumps are much more efficient than electrical resistance heating. It is possible to obtain 300 per cent efficiency from a heat pump at 15 degrees C. In comparison with the heat that electricity can create through resistance, three times as much heat can be extracted from the air or ground and moved into a building. Air source heat pumps are especially efficient when the outside temperature is not too low, such as in the spring and fall in most areas of Canada. Currently, the established technology works down to about minus 10 degrees C, which will not suffice as the only heat source in most of Canada. Some manufacturers are now claiming that their new cold climate heat pumps can deal with outside temperatures as low as minus 25 C or minus 30 C. However, heat pumps tend to produce a lower temperature heat than burning fossil fuels, or resistance heating, and therefore they don’t heat a building as quickly. That means to use a heat pump, a building needs to be airtight and well insulated to keep the heat from escaping, and to reduce the “heating load”.

The economics of heating with electricity Switching to any form of heating via electricity usually results in lower GHG emissions, with the exception of provinces where electricity is largely generated by burning fossil fuels, such as Alberta, Saskatchewan

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JULY/AUG 2021 and Nova Scotia. In other words, electric heating does not save as much in emissions if generating the electricity uses carbon. Where a substantial amount of coal, coke or oil-based fuel is used, converting to electric heating might even increase GHG emissions. At current energy prices and retrofit costs, it is not economic to convert from natural gas to heat pumps anywhere in Canada. Compared with the energy provided, electricity is expensive compared with natural gas. In fact, in Ontario, electricity is 4.5 times more expensive than gas. The ratio ranges from 3.8 times higher in Alberta, through 2.5 times higher in Quebec and B.C., to 2.1 times higher in Manitoba. Even with a carbon tax on natural gas of $170 per tonne of GHGs, electricity would still be three times more expensive than gas in Ontario, and close to twice as expensive as natural gas in other provinces. The second stumbling block is the cost of deep retrofits to make rental buildings sufficiently airtight and well-insulated to reduce the “heating load” enough to make heat pumps practical in Canada.

Deep building renovations A major rental housing provider recently evaluated the conversion of a 250 unit apartment building in Ottawa from natural gas to electrically powered air source heat pumps. The main components required for a deep retrofit would be: •  Triple-pane windows; •  Envelope over-cladding with 4” exterior insulation; •  Replacing existing perimeter radiators with a low-temperature perimeter heating system; •  In-suite ventilation units; and •  Replacing all but one gas boiler with heat pumps. The one gas boiler would be retained to be used during the coldest days to supplement the heat from the heat pumps. The in-suite ventilation units are needed because once an over-cladding project is done and the building envelope is “tight”, one cannot rely on leakage around windows and other wall joints to provide ventilation. Instead, mechanical ventilation is needed to avoid humidity and air quality issues (including mold growth). Heat recovery would be included, but outside air has to be heated and moved inside, using fans powered by electricity.

The cost of deep retrofits vs. the on-going savings The retrofit cost would be close to $78,000 per unit. At a 3 per cent interest rate, the interest that would have to be paid on that would be $2,340 per year, or almost $200 per month per unit. Amortizing the capital cost over 30 years would require another $1,600 per year, for a total outlay of $330 per month per unit. Yet, at today’s energy prices, the utility savings would be only $410 per unit per year, or $35 per month, a small fraction of the cost of the required building retrofits. While the natural gas costs would shrink, electricity consumption and costs would go up, not only to power the new heat pumps, but also to power the new building mechanical ventilation, which is needed when the building is sealed. In most other provinces, electricity is somewhat less expensive than in Ontario. However, subject to small variations due to differences in the average temperature in each location, the utility cost savings would still be dramatically lower than the cost of the retrofits needed to achieve them. The utility cost savings would likely range from $38 per month in Alberta to $49 per month in Manitoba. It is not surprising that rental housing providers are not rushing to adopt heat pump technology to heat rental buildings. The utility cost savings rise as the price of natural gas rises, but even with a potential carbon tax of $170 per tonne, natural gas prices are not projected to rise enough to make deep energy retrofits economic. In Ontario, by 2030, the utility cost savings from a conversion to heat pumps could reach $100 per month. At a high natural gas price, using Manitoba’s low electricity rates, the utility cost savings could reach $118 per month. That is still only slightly more than one third of the retrofit cost of $330 per month.

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NATIONAL OUTLOOK Conclusion Rental housing providers need to be alert to the unintended consequences of climate change policy measures. Before installing higher efficiency heating equipment, making buildings airtight and well-insulated to reduce the heating load can be a good plan, because those measures support costeffective building heating via any means. However, care must be taken to leave enough ventilation to avoid the need for mechanical ventilation, or the costs of adding mechanical ventilation need to be factored into the retrofit and operating costs. Choosing upgraded furnaces or boilers should be done with an eye to how much energy they will save, how much emissions they will eliminate, and how long they will last, as well as the tie-in with building ventilation. Heating technology, energy costs and building regulations are likely to change significantly over the next 30 years.

MOBILE FRIENDLY

Finally, stay informed by continuing to read National Outlook and RHB Magazine. Support CFAA and your provincial or regional apartment association(s) so that we can continue to mitigate moves against the interests of rental housing providers, and support energy measures that are cost-effective, fair and reasonable.

THANK YOU TO OUR CFAA-VRHC 2021 SPONSORS!

The tradeshow sponsors’ virtual booths are still available at:

www.CFAA-FCAPI.org CFAA expects to host CFAA-RHC 2022 in Toronto in May 2022. If you are interested in sponsoring, please contact CFAA at events@cfaa-fcapi.org.

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RHB Magazine August 2021 - National Outlook  

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RHB Magazine August 2021 - National Outlook  

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