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Common Issues in Waterfall Calculations in Commercial Real Estate

Real Estate Professionals (the “Sponsor”) commonly create Real Estate LP/GP Structures as a tool to facilitate the acquisition of real estate assets and structure these acquisitions with multiple investors.  These structures provide investors (“Investor”) with an opportunity to invest in large real estate acquisitions that they may otherwise do on their own.  The Sponsors leverage this tool to raise capital for purposes of acquiring real estate assets they have identified.  In order to compensate both Investor and Sponsors equity waterfall calculations are incorporated in Limited Partnership Agreements (“LPA’s”).

Real Estate Waterfall models in commercial real estate deals are one of the most challenging concepts to understand when dealing with cash flow distributions.  The Waterfall is the approach for splitting free cash flow among Investor and Sponsor in a real estate investment that allows for uneven distributions.  This type of planning provides an incentive bonus to the Sponsor to participate in a disproportionate share of the returns.  This bonus is often called ‘the promote’.

The Waterfall model typically includes a preferred return and a return hurdle rate.  Internal Rate of Return (IRR) is commonly used as the hurdle rate.  IRR is a metric that identifies to an investor the average annual compounded return they have realized from a real estate investment over time, expressed as a percentage.

The preferred return is the first claim on free cash flow distributions.  Once the preferred return, expressed as a percentage, is achieved then any excess free cash flow is split as agreed.  The LPA will also deal with the following elements for the preferred return model.

  • Which equity investors receive the preferred return?
  • Is the preferred return cumulative?
  • Is the preferred return compounded and at what frequency?

The Business Deal

A real estate investment opportunity may include a waterfall calculation that provides the Limited Partner with a cumulative rate of return (“Preferred Return”) equal to a nominal annual rate of 7% per annum compounded semi-annually on invested capital.  After the 7% preferred return has been achieved, all additional cash flow distributions up to a15% IRR will be allocated at a proportion  of 25% to the General Partner and 75% of the Limited Partner.  After a 15% IRR hurdle has been achieved, all additional cash flow distributions will be allocated at a rate of 50% to the General Partner and 50% to the Limited Partners.

Common Issues

Model Frequency

LPA’s will often specify when capital contributions are deemed to be made.  Most commonly this will be stated as the actual day of activity.  This becomes important when determining the amount of preferred return attributable to a capital contribution when the preferred return is expressed using an annual rate.

Let’s determine the preferred return on a $100,000 capital contribution made on January 1, 2021 and subsequently distributed on August 1, 2021.  If we simply took the number of days the contribution was outstanding and prorated over 365 days, we would calculate the preferred return to be $4,085.  Using XIRR function in excel this preferred payment provides an XIRR of 7.14% which is higher than the required rate of return of 7%.  However, if we applied a more accurate rate of return formula using (1 + Rate) ^ (number of days / 365) we would calculate a preferred return of $4,008.  The use of this approach prevents an overpayment of preferred return by 1.92%.

Hurdle Rate Compounding

The compounding period for the hurdle rate will also affect the calculation of the effective rate of interest.  In the above example the nominal 7% preferred return compounded semi-annual equates to an effective annual interest rate of 7.12%.  If only the nominal rate of return is used, then the preferred return per annum would be understated by $120 per annum.

Calculating the accrued preferred return on initial capital contributions

The preferred return is calculated on the initial capital contributions using the preferred rate of return outlined in the LPA.  The preferred return may either be calculated on a cumulative or noncumulative basis.  A preferred return calculated on a cumulative basis is added to the initial capital contributed.  Distributions are deducted from the cumulative preferred return earned.  The LPA needs to clearly specify what events can cause the initial capital contribution to be reduced.  These events are typically restricted to the sale of the real estate asset or refinancing.  Under these circumstances the preferred return earned in the current period cannot be reduced if the previous periods distributions exceed the preferred return.  If the initial investment was $100,000, for 90% of the equity, with a preferred return of 7% in year(s) 1 to 5, the real estate investment returns $10,000 per year.  If the preferred return is calculated assuming that cash flow distributions in excess of the preferred return are a reduction to the initial capital contribution instead of a distribution, it is subjected to a waterfall calculation.  This may cause an overstatement of distributions to the initial capital contribution.  Over a 5-year period this overstatement will be $2,252 or 4.46% of the total distributions.

Understanding the economic terms of a real estate transaction are critically important in ensuring that returns to investors are consistent and correctly calculated in accordance with the LPA and the marketing materials that may been shared with the investors.

Written by Segal LLP Managing Partner, Dan Natale CPA, CA.

Partnership Announcement

Segal LLP is pleased to announce the firm’s two new partners.

Candy Hsieh, CPA, CA, and Jason Montgomery, CPA, CA, have joined the firm’s partnership group, effective January 1st, 2021.

Candy Hsieh joined Segal in October of 2006. She plays an integral part of Segal’s assurance and advisory practice. She has extensive experience in providing clients with tax planning and leading audit, review and compilation engagements across  a multitude of industries including owner-managed companies, non-resident corporations with subsidiaries in Canada, private equity groups, real estate, financial services and professional services.

Candy is a dedicated client service professional who provides her clients with results that are both strategic and practical when requested to assist in their personal and financial matters. Her strong analytical, business and tax skills together with a consistent collaborative approach has enabled her clients to achieve their goals. She has earned her clients’ appreciation for protecting their assets and minimizing their taxes.

Jason Montgomery began his career at Segal in 2004 as the firm’s first ever co-operative education student out of Wilfrid Laurier University, where he graduated from the Honours Bachelor of Business Administration program (2006).

Jason is a trusted advisor at Segal LLP as part of Segal’s assurance and advisory practice.  He is responsible for delivering exceptional service to clients across various industries including retail, wholesale/distribution, financial and professional services, information technology, construction, real estate and not-for-profit.  Clients appreciate his insight into their financial results and his help with advising on tax matters.

We extend our sincere congratulations to both Candy and Jason and welcome them to the Segal partner group.

Candy Hsieh


Jason Montgomery

416-774 2487

Revised form T1134 coming in January 2021

The Canada Revenue Agency (CRA) will release a revised version of the form T1134, Information Return Relating to Controlled and Non-Controlled Foreign Affiliates, in January 2021. The revised form will require taxpayers to furnish detailed information and events within the group of foreign affiliates. The revised form T1134 will take into consideration the last legislative amendment made in the year 2012 as well as address the CRA’s crucial business requirements and some of the concerns brought forward by the tax community on compliance.

In order to allow for taxpayers to be prepared for the changes, the CRA has released a preview of the revised form. The new version of the form T1134 will be effective for taxation years or fiscal periods that begin after 2020 and must be filed no later than 10 months from the taxpayers’ year-end. For taxation years or fiscal periods that begin in 2020, the old form T1134 will continue to be used and must be filed no later than 12 months from the taxpayers’ year-end.

Highlights of the key changes to the form T1134 are discussed below.


The form T1134 is required to be filed by Canadian resident taxpayers including corporations, individuals, trusts, and certain partnerships[1], for any year in which the taxpayer has an interest in a controlled or non-controlled foreign affiliate, in the year. The form T1134 contains a summary form and a supplement form that is filed separately for each foreign affiliate.

A “foreign affiliate” is a non-resident corporation in which the taxpayer owns, directly or indirectly, at least 1% of any class of the outstanding shares of the foreign corporation, and the taxpayer, alone or together with related persons, owns, directly or indirectly, at least 10% of any class of the outstanding shares of that foreign corporation. The foreign affiliate will be a controlled foreign affiliate if certain conditions are met (e.g., more than 50% of the voting shares are owned, directly or indirectly, by a combination of the Canadian taxpayer, persons dealing at non-arm’s length with the Canadian taxpayer, a limited number of Canadian resident shareholders, and persons dealing at non-arm’s length with these Canadian resident shareholders).

New reporting requirements and questions in revised form T1134 for taxation years beginning after 2020

Changes in the new form T1134What are the additional reporting requirements?
  • Activity(s) of the reporting entity specifically focusing on reorganization transactions undertaken by such reporting entity.
  • Surplus account balances – for low tiered foreign affiliates that are held indirectly through other non-controlled foreign affiliates, focusing on transactions and events that affect surplus account balances (not required in existing form T1134).
New questions pertaining to
  • The reporting entity’s role in transactions and arrangements in the context of legislative amendments enacted since 2012, including upstream loan rules, foreign affiliate dumping, tracking interests, and pertinent loan or indebtedness elections.
  • Elections made in the context of foreign affiliate dividends to the reporting entity or any other affiliate company of the Canadian group.
New requirements for
  • Breakdown of the gross revenue of each foreign affiliate, including if the source was arm’s length or non-arm’s length.
  • The adjusted cost base of the foreign affiliate’s shares that the reporting entity owns directly (by way of common and preferred shares) and details of any changes that took place during the year.
Carry forward losses and FAPI
  • Details that will help determine if amounts were carried forward (such as foreign accrual property losses [FAPL] and/or foreign accrual capital losses [FACL]) to reduce the amount of foreign accrual property income (FAPI) reported for the year. Additionally, FAPL and FACL amounts will require to be reported.
Questions on foreign affiliate reorganization(s)
  • Details of reorganizations undertaken by the foreign affiliate, including liquidations, mergers, share for share exchanges, and convertible property transactions.

Measures to ease the burden of compliance

The revised form T1134 includes several changes that have been welcomed as a means of reducing the compliance burden on taxpayers. These include:

  • Joint filing option for a group of reporting entities that meet the following conditions:
    • are related to each other
    • have the same year-end
    • report in Canadian dollars or an equivalent functional currency

This will allow reporting entities to jointly file one set of T1134 summary and supplements for all foreign affiliates.

  • Exemptions from filing the form T1134
    • the threshold of total gross receipts increased to $100,000 (from $25,000) to determine the status (e.g., dormant or inactive) of a foreign affiliate.
    • exemption criteria only applied to the individual entity.
  • Unconsolidated financial statements for foreign affiliates
    • Reporting entities to only provide unconsolidated financial statements of each foreign affiliate in which it holds at least 20% of the voting shares and not for all foreign affiliates.
  • Removal of financial data fields from existing form T1134
    • The new form T1134 removes existing disclosures under Part II – Section 3 that discloses total assets, accounting net income before tax, income tax paid or payable, as well as reporting entity information in Part II – Section 1.
  •  Organization chart
    • Reporting entities can file their organization chart electronically and will not be required to complete it in a tabular format.
  • Number of employees
    • Reporting entities to disclose the total number of employees employed throughout the year by each foreign affiliate on an entity-specific basis instead of a business segment basis (where a foreign affiliate engages in multiple businesses).
  • Debt owing to or from foreign affiliates
    • Where a reporting entity has not disclosed the gross amount, it is owed from or owes to a foreign affiliate in its form T106, it discloses such information in the new form T1134 by answering a series of questions.

What should taxpayers do to prepare?

The CRA’s introduction of revised form T1134 requiring comprehensive information on foreign affiliates is aligned with the global trend in tax authorities developing and implementing mechanisms to enable enhanced tax transparency. These initiatives follow the launch of the Base Erosion Profit Shifting (BEPS) project by the Organization for Economic Cooperation and Development (OECD). While it will be critical that taxpayers have systems and procedures to gather and furnish this information, this might be an appropriate opportunity to rely on the data-gathering exercise to rationalize corporate structures and identify any risks/gaps that might exist in the value-chain and develop strategies to mitigate them.

With the new form T1134 being introduced in January 2021, taxpayers should ensure the information on surplus calculations and adjusted cost base of foreign affiliate shares are up to date. Considering the new reporting requirements and a shorter deadline to file (10 months) the new form T1134, taxpayers should also consider how such additional information will be gathered specifically covering details in the context of upstream loans, foreign affiliate dumping, and elections made.

Furthermore, for Canadian headquartered multinational groups that meet the consolidated threshold of EUR 750 million requirement to file a Country-by-Country Report (CbC), it will be important that some of the information disclosed on related party foreign affiliates in the new form T1134, be consistent with the CbC Report, where appropriate. Furthermore, taxpayers implementing processes and procedures to gather information to include in the CbC Report should evaluate changes required to their systems to integrate the form T1134 reporting requirements and leverage efficiencies.

How Segal LLP can help?

Our multi-disciplinary tax and transfer pricing teams can assist taxpayers with complex reporting requirements and use such information to manage potential risks identified. This information can be used to determine completeness and accuracy by simulating it in advanced analytical tools and the outcomes can then be “risk classified” in the context of an ever-evolving international tax and transfer pricing environment.

For more details on how we can help, contact one of our Tax Partners Andrew Shalit, Howard Wasserman, Dora Mariani, or Principal & Transfer Pricing Leader Avinash S. Tukrel.

[1] If the share of the income or loss of the partnership for the year of non-resident members is less than 90% of the income or loss of the partnership, and a non-resident corporation or trust would be a foreign affiliate of the partnership if the partnership were a person resident in Canada

2020 Tax Planner

Dear Clients, Friends & Associates,

As we come to the end of 2020, our tax team has been busy compiling a list 
of tax planning ideas that may potentially increase tax savings for you and your
family members. The topics included in this year’s tax planner include:

  • New Tax Rules
  • Personal, Trust and Corporate Tax Changes
  • Personal and Corporate Year-End Planning
  • Key Dates
  • Personal and Corporate Tax Rates

Segal’s 2020 Tax Planner is viewable here.

Should you have any questions or concerns, your Segal advisor can assist you
in determining which of these ideas is the best fit for you.

Please do not hesitate to call your Segal advisor or our tax team with any
questions about this year’s tax planner.

Thank you,

Segal LLP | Taxation Services

Segal Recognized By CLA

Segal LLP is pleased to announce that we served as advisors to the Aquilini/Enthusiast merger which has won the Excellence Award for the Capital Markets Deal of the Year by the Canadian Law Awards.

We also want to extend a congratulations and a job well done to our own team from Segal who provided audit and advisory services as part of this transaction. We pride ourselves on a diverse, experienced and hard-working team and we are thrilled to be recognized.

View the full list of 2020 Winners and Finalists here.