Tax fallout could bite part of O&Y sale proceeds

The tax fallout of the proposed $2-billion purchase of O&Y's office portfolio could shave more than $1 off the $15.50 offer price for units of the real estate investment trust for some investors, and has fund managers questioning the deal.

O&Y REIT said yesterday that because of the structure of the transaction involving a group led by Brookfield Properties Corp., up to $2.80 of the purchase price for trust units could be classified as ordinary income. For investors who hold units outside a tax-sheltered retirement account, that could mean they see close to half of that $2.80 clawed back by the taxman.

"That's a lot," said one fund manager who is a major investor in the REIT, but did not want to be named. "People are not happy. I wouldn't count this as a slam dunk."

Another long-time fund manager with a significant holding said that, given the tax hit, he is better off rejecting the deal and continuing to collect monthly distributions. "I'm better off not selling. We still have the option of turning it down and keeping our cash flow."

Reaction to the deal is shaping up to be the latest example of shareholders flexing their collective muscle to push for improvements in proposed takeovers. Investors had expected a tax hit but only yesterday learned the exact amount.

Under terms of the deal announced last week, the buyer group will make a cash offer of $13 a share for Toronto-based O&Y Properties Corp., a proposal that hasn't raised objections from shareholders. O&Y Properties owns only one building directly -- Toronto's First Canadian Place. It has an interest in the remaining O&Y office towers through its stake in the REIT.

The proposed purchase of the related REIT is more complex because the offer by the investor group is for the 24 buildings it owns, not the trust itself. That means the trust must be legally dissolved and unit holders paid out, an action that will trigger the unfavourable tax treatment. "If they were buying the units, there wouldn't be this issue," one major investor said. "They are basically stuffing us with the tax consequences."

An official with O&Y said she could not comment on the reasons for this structure. Floriana Cipollone, a vice-president for both O&Y Properties and the REIT, said the companies have received only a few calls from investors on the tax issue.

Buyers of the O&Y real estate portfolio, which is the largest to change hands in Canada, also include Canada Pension Plan Investment Board and an arm of the Alberta government, Alberta Investment Management. The group was the top bidder in a lengthy process to sell the office portfolio.

For that reason, some said yesterday it is unlikely the group will sweeten the offer, even if it is less than what many were hoping for.

O&Y Properties, which holds 42 per cent of the REIT units, supports the deal. But for the transaction to be complete, a majority of the remaining unitholders must give their approval.

One analyst who follows O&Y said the news is not as bad as it might seem. He said unitholders of the REIT can avoid the tax hit by selling their units before the transaction date of the deal. Since the REIT will pay out a 9-cent distribution this month and units are trading below the $15.50 offering price, he predicted there will be arbitrage buying by pension funds unaffected by the tax treatment.

But one fund manager yesterday dismissed this option. "Why should I transfer some of my cash flow to an arbitrager to compensate for a bad deal?" He also said the option is not practical for managers with large positions.

Fund managers contacted yesterday say they are waiting for further details of the deal before deciding how they will vote or to go on the record with their opposition. O&Y said yesterday it will deliver information circulars to investors of both firms on June 15.

At least one fund manager expressed his disapproval of the deal right away. Last week, T. Ritson Ferguson, chief investment officer at ING Clarion Real Estate Securities, the REIT's largest shareholder, told Dow Jones Newswires that he felt the offer was "inadequate."