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Commercial Real Estate Investing in Atlantic Canada: 10 Key Legal Considerations

Published:

November 5, 2021

Author(s):

• James Mosher
• Sean Corcoran
• Jonathan Pendrith
• Meghan King

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Purchasing commercial real estate as an investment, as a component of a business startup or as one asset in the share purchase of an existing business, entails entering into a contract – and assuming legal liability risks. A typical commercial property transaction can take several months to complete, during which the buyer will need to make many decisions about how the transaction will be structured, and whether to complete the transaction at all. It’s key that buyers know what risks they’re taking on, and how to manage those risks. Here are ten of the key legal considerations for individual or corporate buyers to keep in mind when purchasing commercial real estate in Atlantic Canada.

1. The Nature of the Buyer

Whether the buyer is an individual or a corporation entails both benefits and drawbacks.

Tax Implications. Rental income from real estate an individual owns is added to the owner’s other earnings and subject to income tax at their personal tax rate. Rental income from real estate a corporation owns can be taxed at a higher effective tax rate than the personal tax rate unless the rental income is considered active business income in the corporation. When the income is considered business income, a corporation will pay tax at a lower corporate tax rate and defer a significant portion of the overall tax on that income until the funds are paid out to a shareholder as a dividend. It’s therefore wise for a corporate buyer to seek advice from a tax advisor to determine whether a particular corporate entity will qualify for a lower corporate tax rate after the purchase transaction.

Creditor Proofing. Real estate that a corporation owns is typically unavailable to satisfy the personal creditors of any individual shareholder. However, the shares of the corporation that owns the real estate are available to satisfy its shareholders’ personal creditors.  Therefore, a corporation alone isn’t an effective tool to creditor proof from personal creditors. But there are creditor proofing strategies used to protect the real estate from the creditors of an operating business. It can be an effective creditor proofing strategy to use a corporate structure that includes both:

• A real estate holding company, which doesn’t carry on any business activities other than to lease the property to an operating company.
• A separate operating company that carries on business.

This is effective because the operating company’s creditors can only look to the operating company’s assets to satisfy any debts.

Ownership Shares. A corporation’s shareholders don’t have any direct ownership interest in property the corporation owns. Even if the corporation has only one shareholder who acts as sole director and president, the corporation’s assets aren’t the shareholder’s assets. The shareholder(s) only owns corporation shares and is only entitled to the assets of the corporation that are given to them through a dividend or upon windup or dissolution of the corporation. An understanding of the corporation’s share structure is important, and it’s necessary to examine the rights attached to different classes of shares to determine relative ownership of a corporation among its various shareholders. For example, if one shareholder owns 100 Class A Common shares and a second shareholder owns 100 Class B Common shares, this doesn’t necessarily mean each shareholder owns 50% of the corporation. One class of shares might entitle the holder to 10 times the votes, dividends and/or rights to assets on dissolution as the other class entitles its holder to. Finally, it’s also important to understand that the percentage ownership of a corporation is a point-in-time determination; when a corporation issues additional shares, it dilutes the ownership interest of all existing shareholders. It’s wise to discuss the share structure with your lawyer when structuring the purchase transaction so you fully understand what’s appropriate for each individual situation.

IRAC Approval in P.E.I. If the real estate is in P.E.I. then depending on the particular property, its purchase by a corporation could require approval from the Island Regulatory and Appeals Commission (IRAC) under the P.E.I. Lands Protection Act. This adds both time (it typically takes one month to get a decision), expense, and a degree of uncertainty to the purchase transaction. The purchase of the same real estate by an individual who’s “resident” in P.E.I. might not require IRAC approval; the purchase by an individual who’s “non-resident” in P.E.I. might still require IRAC approval.

2. The Nature of the Seller

Whether the seller of the real estate is a corporation or an individual affects the information the buyer’s lawyer needs from the seller as part of their due diligence to protect the buyer’s interests in the transaction.

Corporate Seller. If the seller is a corporation, the buyer’s lawyer will require certain documents from the seller to evidence:

• The corporation is in good standing. This is typically accomplished with the provision of a “Certificate of Status” from the jurisdiction in which the corporation was incorporated. If the property is located in a different jurisdiction, a certificate confirming registration in the jurisdiction in which the property is located will also be requested.
• Encumbrances against the corporation that would form a charge against its assets. To confirm there are no such charges, searches against the name of the corporation will be necessary. Some typical due diligence searches on the corporate seller (in addition to due diligence on the property) include searches of or under the: applicable employment standards law; applicable workers’ compensation law; applicable provincial  finance, revenue and taxation law; the Canada Revenue Agency (CRA); the Bankruptcy and Insolvency Act; federal and provincial court litigation records; and of Sheriff’s Certificates (for writs of execution).
• The seller corporation has properly authorized the sale. Because a corporation is a legal creation that can only act through its directors and officers, a buyer must confirm the seller corporation has approved the proper authority to sell the property. This authority is typically confirmed with the seller’s provision of an Officer’s Certificate of the seller corporation confirming: the corporation’s constating documents, its directors, officers, shareholders and by-laws; and a copy of the appropriate corporate shareholders’ resolutions and/or directors’ resolutions approving the transaction.

Individual Seller. If the seller is an individual, the buyer’s lawyer will require certain assurances about:

• Whether the individual seller is the sole owner of the real estate. If the property is held in a form of joint ownership, all other owners will also need to sign the agreement of purchase and sale and closing documents.
• Whether the individual seller is married. If so, it’s necessary to inquire as to any marital property interest and obtain and include a spousal affidavit in the documents.
• Encumbrances against the name of the individual seller that would form a charge against their assets. To confirm there are no such charges, searches against the name of the individual seller(s) are necessary. Since an individual can carry on business as a sole proprietor, the typical due diligence searches on the seller (in addition to due diligence on the property) include those for a corporate seller.

 3. The Nature of the Property

An important consideration with the purchase of any real property is the nature of the property being purchased.  A property that has been used for industrial purposes, or is located in the vicinity of properties used for industrial purposes, has a greater risk of environmental contamination than undeveloped lands.  A property that has many work order deficiencies can be a red flag as to the quality of a building. To identify all such risks, and to ensure that the property is appropriate for its intended purpose, the buyer can complete property due diligence inquiries such as:

• Real property taxes.
• Zoning of the current property to ensure it permits the intended use.
• Clean environment /clean water laws.
• Work orders and permits related to building inspection, occupational health and safety, fire department/fire marshal, labour department, and the appropriate governmental authorities for regulating boilers, electrical installation, elevators/lifts, and plumbing.
• If the buyer is purchasing personal property along with real property, searches at the Personal Property Security Registries for the specific province might also be required.

 4. The common documents the buyer must sign & the consequence of signing them

The purchase of commercial real estate can require the buyer to sign many documents – each of which carries consequences. The common documents include:

Letter of intent (or “LOI”). An LOI specifies one party’s intentions toward the other party(ies), laying the ground work for the final Agreement of Purchase and Sale of the real estate. A LOI is typically not legally binding, but it can include some binding components. If the parties decide to go ahead with the transaction, many of the LOI terms will form part of the final Agreement. An LOI is especially useful when the buyer has had preliminary discussions with the seller and has a general outline of what they want the deal to look like. An LOI can also be helpful to show potential financing providers what the financial terms of the agreement will look like.

Non-disclosure agreement (or “NDA”). An NDA is commonly used when purchasing rental property, though sometimes also used in non-rental real estate purchases. An NDA allows a selling landlord or real estate agent to disclose financial or confidential tenant information to a prospective buyer in an effort to sell the real estate. In turn, the prospective buyer is obligated to keep all information private and not use it outside of the purchase transaction, or the selling landlord will have a legal right to seek a legal remedy, including compensation, from them in court.

Agreement of purchase and sale. As part of the purchase transaction both the buyer and the seller typically sign a contract or Agreement of Purchase and Sale. In Prince Edward Island, Nova Scotia and Newfoundland & Labrador, an agreement for the purchase and sale of land (including any buildings on that land) must be in writing to be legally enforceable; even if it’s not required, however, putting it in writing is highly recommended, and typically done. An offer to purchase land remains open unless and until it’s revoked by the potential buyer, until it expires according to an expiration date that’s set out in the offer (if there is one), or until the seller accepts it.

5. The Terms of the Agreement of Purchase & Sale

An Agreement of Purchase and Sale can be a lengthy and complex document. It’s critical to understand what you’re agreeing to before you sign an Agreement of Purchase and Sale: if you back out of it after signing, there could be significant financial and legal consequences. Real estate agents often provide a “template” or “standard form” Agreement of Purchase and Sale. But before signing it, given the consequences of doing so, it’s good practice to have a lawyer review the Agreement or, better yet, have your lawyer draft the Agreement so they can tailor it to your specific situation. While every Agreement of Purchase and Sale will be unique to the particular transaction, they typically include these key elements:

Who, what and how much. The names of the seller and the buyer, identification of the real estate being sold / purchased, and the purchase price. Be clear whether the stated purchase price does or does not include tax (if it applies).

Closing date. The date on which the transaction will take effect. Make sure it’s not a weekend or a holiday on which the relevant land registry office isn’t open – and thus the necessary documents can’t be registered to close the transaction.

Objection date & delivery. Practically, the date (or dates) by which the purchaser must raise any objection must be far enough away to allow enough time to conduct a full title search, as well as other due diligence searches, on the property being purchased. Ensure the Agreement allows objections to be delivered to any of the vendor, their lawyer, or their agent; if the due diligence searched reveal issues with the title to the real estate or any other matter, your lawyer can clearly identify objections and the required resolutions directly to the seller’s lawyer, potentially avoiding or minimizing any delays or issues.

Representations & Warranties. In commercial real estate transactions, sellers either sell on an “as is” basis with no or very limited representations and warranties, or both the seller and the buyer make representations and warranties. A representation is a statement of fact that the party asserts to be true when it’s made; a warranty is an assurance one party gives to another in a contract as to the existence of a fact upon which that other party can rely, and generally states that such fact will be true on the closing date. Where the seller and the buyer do make representations and warranties, the goal of each should be to share information that they know, but that would be expensive for the other to ascertain independently. It can be in the seller’s best interests to provide the buyer with detailed representations about the property. If the seller does so, the buyer might be able to lower its transaction expenses to complete due diligence on the property (such as by reducing the level of environmental assessment completed). Lower transaction expenses for a buyer could allow a higher purchase price to the seller, without changing the overall transaction price to a buyer.  However, the seller’s representations and warranties still don’t completely replace the buyer’s own due diligence – but they do provide important information and assurance to the buyer, and allocate the risk between the buyer and the seller.

• The seller of a commercial property has a legal “duty to disclose”. However, unlike residential real estate transactions, in a commercial real estate transaction there’s no disclosure “template”. The principle “buyer beware” applies in commercial real estate transactions – but there are numerous exceptions obligating the seller to make certain disclosures, including: latent defects in the property (defects that can’t be discovered on a reasonable inspection of the property) that make it dangerous, a health hazard or unfit for habitation; environmental contamination; and fraud. Condominium developers are obligated to make additional disclosures to a buyer.

• In larger transactions, the buyer’s advisors will prepare a separate disclosure document containing lists of questions and the seller will provide responses. The seller’s disclosure will inform the representations & warranties the buyer will require the purchase & sale agreement include. Disclosure information requests will include questions like: What was the seller’s use of the property? Has there been a change in use of the property? What materials are used in the construction of the property? What’s the history of the property? What are the known defects?

• The scope of the seller’s representations and warranties provided depends on numerous factors, mainly pertaining to market forces and the bargaining power between the buyer and the seller. They typically relate to the seller’s knowledge of the property, assurances related to the property (such as its use), and matters that the buyer can’t easily discover on its own.

Allocation of Purchase Price. Primarily for accounting purposes, the purchase price must be broken down between the land, building and equipment (as applicable).

Conditions of sale. The Agreement will also set out the key contractual conditions to which the closing of the transaction is subject. The particular conditions will vary depending on the transaction and the Province, but typically include one or more of these:

• Financing.
• Property Insurance.
• Building inspection.
• Environmental assessment (depending on the use of the property, the buyer might consider a Phase One Environmental Report).
• In Newfoundland & Labrador, a survey and Real Property Report.
• Evidence the seller is a resident of Canada within the meaning of the Canadian Income Tax Act or, failing such evidence, that the seller has delivered the requisite certificate from the Canada Revenue Agency (CRA).
• The right of the buyer to view and inspect (through a qualified building inspector) the property before closing.
• Any rezoning of the property required to allow the buyer’s intended use.
• Migration of the legal title to the property from an older, registry of deeds land registration system to a newer, land titles registration system if it hasn’t yet been done, and review of the legal title to the property. This could apply in New Brunswick and Nova Scotia. Newfoundland & Labrador and Prince Edward Island, however, have not (yet) changed their systems of recording legal title to land, so typically require a condition requiring good and marketable title, free from any and all encumbrances.
• No adverse due diligence search results that the seller is unable or unwilling to rectify prior to the closing date of the transaction.

Boilerplate legalese. Don’t skip these “standard” legal clauses, like “Entire Agreement” (this Agreement is the entire agreement; there are no “side deals”), assignment (whether the seller or the buyer or both can assign the Agreement to another party), and execution (signatures of the parties and witnesses) clauses. They might be hard to understand, but can be very important, particularly if there’s any subsequent dispute between the seller and the buyer.

6. The role of Title Insurance

It’s important for the buyer to consider whether to obtain title insurance as part of a property purchase transaction. Title insurance is separate and apart from “Property Insurance”. Property Insurance insures against a future event, such as a fire, an accident, or death. Title Insurance is an agreement to indemnify: it insures against a future loss that’s caused by a covered defect that’s present as of the date the policy is issued. If at some time after you purchase real estate, it’s discovered the title to that real estate has a defect that the title insurance policy covers, title insurance insures against the risk the owner will suffer a loss as a result of that title defect. There are two types of title insurance: owner insurance and lender insurance. If the buyer is financing the purchase through a lender, then lender title insurance should also be added. There’s no annual premium for title insurance; a single premium is paid when the policy is issued and it remains in effect until the real estate is transferred. Title insurance is also generally much cheaper than having the real estate surveyed to confirm the buildings are on the property and that no encroachments from neighbouring properties exist (although in Newfoundland & Labrador, title insurance doesn’t cover these issues unless the buyer has obtained a Real Property Report, similar to a survey). Each title insurance policy is unique to the real estate that’s insured, but title insurance doesn’t cover everything; there are certain exceptions, such as environmental risks, that title insurance won’t cover. It’s important to understand the scope of the particular policy.

7. The applicability of Harmonized Sales Tax (HST)

Whether HST is payable on the purchase of the property depends on its nature. Generally, HST is payable on the sale of a commercial property. HST is also payable on the sale of a new building. However, generally HST is not payable on the resale of residential property, including apartment buildings. Where a property is partly commercial and partly a used residential complex, HST is payable only on the portion that’s commercial. If the commercial purchase includes equipment, HST might also be payable on the equipment portion of the sale. Generally, HST is payable by the buyer and collectible by the seller. When the seller is a non-resident of Canada, the buyer must withhold a specified amount from the proceeds of the sale until the Canada Revenue Agency (CRA) issues a “Certificate of Compliance”. The amount the buyer must withhold is specified by CRA and is intended to insure sufficient funds in Canada to pay all taxes owing by the seller on the transaction (including income tax on capital gains). Otherwise, if the seller doesn’t comply with the Canadian Income Tax Act, the buyer could become liable to pay the tax on the seller’s behalf.

8. Allocation of the purchase price for depreciation purposes

The allocation of the purchase price between the land, building and equipment (as applicable) is important because it affects the buyer’s ability to defer payment of taxes in the short term. Capital Cost Allowance (CCA) is the means by which Canadian businesses can claim depreciation expenses to reduce their taxable income in a given year. It’s currently calculated at 0% for land, 4% for buildings, and 20% for equipment. Sellers often want to allocate as much of the price as possible to non-depreciable capital assets (land). This is because if the allocation toward buildings and equipment exceeds the Undepreciated Capital Cost (UCC) on the seller’s financial records, the Canada Revenue Agency (CRA) would consider the amount by which the sale price exceeds the UCC to be a “recapture” of previously claimed CCA on those assets and included in the sellers regular income for that year, as opposed to a capital gain which has a lower effective tax rate. However, buyers often want to allocate as much as possible to depreciable assets with the highest depreciation rates (equipment and building).  It’s very important to explicitly state the agreed-upon allocation in the Agreement of Purchase and Sale, and to include a covenant that the seller and the buyer will prepare all income tax filings in accordance with that allocation.

9. Rental properties

If the property being sold and purchased is a rental property, a buyer must keep some additional legal considerations in mind.

Lessee / tenant due diligence. It’s important that the buyer ascertain whether the buyer is getting vacant possession of the property, or are there tenants in place, and if so, the nature of the tenants (residential or commercial).

Closing adjustments. If the buyer is purchasing a property with tenants in place, the buyer (or their lawyer) will want to obtain information from the seller regarding such tenants so appropriate adjustments to credit the seller and the buyer with the rents and deposits paid can be made. In New Brunswick, Nova Scotia and Prince Edward Island, this information is provided in a document called a Rent Roll, which contains:

• The names of tenants.
• The rent being paid.
• The existence of any written lease(s) and, if so, a copy.
• Any damage deposits paid, when they were paid, and who is holding the deposit.
• Whether any of the tenants have prepaid rent.
• The length of tenancy.

In Newfoundland & Labrador, the buyer’s lawyer must obtain and review a copy of the lease from the seller’s lawyer to confirm this; in a commercial transaction, the buyer’s lawyer might also require the tenant(s) to provide an estoppel certificate confirming this information. Estoppel certificates are also common in most commercial transactions in New Brunswick and Nova Scotia.

Lease review. If there are existing tenants, it’s critical that the buyer (or their legal counsel) conduct a careful review of the leases in relation to the rental property, including to confirm the leases are assignable to the buyer as the new landlord. Otherwise, new lease agreements between the buyer and the tenants will be required.  In addition, it’s good practice to have each tenant verify in writing that the information contained about their tenancy in the Rent Roll is accurate and correct.

Post-closing notification to tenants. After the purchase transaction closes, the seller is obligated to notify any tenants that the property has been sold with a direction from the seller to pay future rents to the buyer. Generally, the seller provides this form of notification to the buyer on closing, and the buyer will provide it to the tenants to ensure delivery. In New Brunswick, where the property has residential tenants, the notice must be in proper form and also provided to the New Brunswick Rentalsman; in Nova Scotia, Prince Edward Island, and Newfoundland & Labrador, there’s no mandatory form of notice or requirement to provide it to the provincial residential tenancies regulator.

10. Financing Requirements

Assuming the buyer is obtaining financing from a commercial lender, the buyer can expect the lender will require a first ranking charge security, typically in the form of a mortgage on the real property.  Additional financing instruments commercial lenders commonly require are:

Personal Guarantee. The lender may require a Guarantee by which the shareholder(s) of a corporate borrower agree(s) to be personally liable for the corporate borrower’s debt if the corporate borrower defaults on its obligations.  The guarantee could be limited or unlimited, generally depending on the bargaining power between the borrower and the lender.

General Security Agreement. The lender might also require a general security agreement giving the lender security over any personal property the corporate or individual borrower, as the case may be, owns, including equipment. In some cases, the lender might also require a general security agreement from the guarantors providing the lender with security over their personal property in support of the guarantee.

Assignment of leases. If it’s a rental property, the lender might require the buyer’s lawyer to investigate that the leases to existing tenants can be assigned from the seller to the buyer. The lender will not only require the leases to be assigned to the buyer, but more importantly, it will also typically require that the tenants formally acknowledge the leases and their assignment to the buyer. The lender will also want to determine whether the leases contain the ability for the owner to grant security in them, whether the lease can be assigned, and the existence of a non-disturbance clause (a clause that allows the tenant to remain in possession of the leased premises, under the lease terms, despite any foreclosure action against the landlord).

General Assignment of Leases and Rents (“GARL”). Lenders often require the buyer to execute a GARL, in which the new owner assigns the leases and the rents to the (lender) financial institution as security for the loan.

Please contact your McInnes Cooper lawyer or any member of our Real Estate Law Team @ McInnes Cooper to discuss how we can help you with your commercial real estate purchase.

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