Feature

posted 13 Oct 2006 in Volume 11 Issue 6

The wait is over: The UK REIT comes of age

The advent of the UK Real Estate Investment Trust spells good news for individuals and trustees looking for investment opportunities. Tracy Fisher reports.

Following announcements in the March 2006 Budget and the passing of the Finance Act in July, the UK real estate investment trust (REIT) is set to become a reality. UK property investment companies will be able to elect into the REIT regime from 1 January 2007. This is likely to herald a new era in property investment in the UK. At last, there will be a UK vehicle that will be able to offer an attractive means of investment in UK property for individuals or trustees who want to invest on a smaller scale, as well as institutional or high-net-worth investors.

Key changes in the proposed REIT regime announced by Gordon Brown during the 2006 Budget have already led to a surge in the listed property sector. Several of the previous reservations expressed by bodies representing the property industry have been addressed by the chancellor and, while there will be continuing lobbying over the precise form of the REIT, the creation of new marketable, liquid and tax-efficient property vehicles is now only months away.

Fully understanding the REIT regime, and its advantages and disadvantages over other UK and overseas property vehicles, will allow your clients to fully maximise the opportunities REITs will present. This article explains why REITs are important and considers their proposed structure and tax treatment. It will also provide some insight into alternative property-investment vehicles.

Why are REITS important?

REITs have been available in many other jurisdictions for some years, most notably, in the US since the 1960s. They are basically tax-efficient property-investment vehicles, predominantly listed and in corporate form.

The introduction of the UK REIT will provide access to commercial property for all types of investors, including individuals and trustees, and should boost the UK property-investment market. There is currently a lack of liquidity in the market, and the establishment of the REIT as a listed vehicle will enhance secondary trading. The government also hopes that residential property REITs will be established, and that this will boost investment into housing in the UK.

Significantly, the REIT will provide a means of tax-efficient co-investment in UK property not currently available for a variety of taxpayers.

Generally, an investment vehicle is tax efficient if it can deliver investors the same overall net of tax return that they would have attained had they invested in the property directly. Vehicles exist at present that offer such tax efficiency (such as offshore unit trusts and limited partnerships), but these are generally unregulated and so cannot be marketed to the public. Instead, retail investors currently invest predominantly through listed property companies; these are inherently inefficient for tax purposes, as tax is payable both at the company and at the investor shareholder level. The REIT, however, will be a tax-efficient listed vehicle that anyone can invest in. The other good news is that shares in a REIT will be eligible investments for ISAs, PEPs and SIPPs.

Overview of the UK REIT

Following the announcements in the Budget, a workable framework for the REIT has been achieved. The following is an outline of both the key conditions that the REIT will have to meet and its structure.

Basic structure conditions

A closed-ended corporate vehicle
A REIT must be a company but need not be UK incorporated. It cannot be an open-ended investment company (or OEIC).

Listed company
The ordinary shares of a REIT must be listed on a recognised stock exchange. This would include not only the London Stock Exchange but also a number of foreign exchanges such as those in
Dublin or Luxembourg. A REIT cannot be listed on the Alternative Investment Market (AIM); this has been the subject of much lobbying, though, and may
change in the future.

UK tax resident
A REIT must be UK resident for tax purposes and cannot be resident elsewhere or be dual resident.

Single class of ordinary shares
A REIT will only be able to have a single class of ordinary share although it will be able to issue non-voting, fixed-rate preference shares.

Shareholder mix
By major concession, it will no longer be a condition for REIT status that no single person directly or indirectly holds more than ten per cent of its shares at any time. Regulations will provide for a tax penalty to be charged in certain circumstances if this happens. Also, the REIT must not, at any time, be a ‘close’ company (defined as a company in which the directors control more than half the voting shares, or where such control is exercised by five or fewer people and their associates).

Loan capital
The REIT may not be a party to any loan under which the creditor’s return is in any way dependent on the financial results or value of the REIT, exceeds a reasonable commercial return, or is not comparable with other listed securities.

Entry charge

The crucial Budget announcement was that the ‘entry charge’ to be imposed on a company converting to REIT status is to be based on two per cent of the market value of its investment properties that will form part of the REIT ‘tax-exempt’ business.

Companies may opt to pay the entry charge straightaway or spread it over four years, in instalments of 0.5 per cent, 0.53 per cent, 0.56 per cent, and 0.6 per cent, paying a total of 0.19 per cent extra if this option is chosen. The charge will be levied as a liability to corporation tax on deemed income; a company will not, however, be able to reduce the charge by setting off trading or capital losses.

Financing costs: profit ratio

An interest cover test is to be introduced that, if not met, will result in a tax charge for the REIT. The basic requirement is that interest cover (calculated by dividing profits plus interest by interest) is to be not less than 1.25, taking account of pre-capital allowance profits. Following lobbying, this has been reduced from the original proposal of 2.5 calculated by reference to profits after capital allowances are deducted. This should permit gearing of approximately 60-70 per cent.

The concept of ring-fencing

Ring-fencing will provide a means of tax-efficient property investment through a REIT while at the same time permitting the REIT to undertake a limited amount of other activities. The REIT will be treated as carrying on two separate activities: a ‘tax-exempt business’ of property rental; and a ‘residual’ (taxable) business comprising other activities such as property trading and development.

The REIT will benefit from an exemption from corporation tax on income and chargeable gains arising from the properties it will hold within its tax-exempt property-rental business. For this, it will need to satisfy prescribed conditions for its tax-exempt property-rental business and the balance of its activities between property-rental and other business.

Meaning of ‘property rental business’

In general, a REIT’s ‘tax-exempt property business’ will include the letting of both UK and overseas property. A number of activities are specifically excluded, such as letting incidental to property development, letting of property primarily held for administrative purposes but temporarily surplus to requirements, and rent factoring.

Income from another REIT is also excluded from being within a REIT’s tax-exempt business. A ‘REIT of REITs’ is thus not possible under the current provisions.

Additionally, the tax-exempt business of the REIT may not be able to include interests in certain collective investment schemes, such as units in offshore unit trusts, although this is yet to be clarified.

Activity conditions

The property rental business carried on by a REIT will only qualify as a ‘tax-exempt business’ if it meets the four activity conditions set out below.

Minimum three properties: the REIT’s property-rental business must comprise at least three properties (but treating a commercial or residential unit as a separate property if it can be let separately);
Spread of value: no single property in the REIT must represent more than 40 per cent of the total value of the properties in the REIT’s property-rental business;
No owner-occupied: no property can be included if it is occupied by the REIT itself or by another company whose shares could be said to be stapled to those of the REIT;
Distribution requirement: the REIT will have to distribute (subject to corporate law restrictions) at least 90 per cent of the profits (after capital allowances) arising from the property rental business by way of dividend within 12 months of the relevant accounting period. This requirement has been relaxed from 95 per cent within six months.

Gains arising from disposals of property held for the tax-exempt business within the REIT need not be distributed provided they are reinvested within 24 months.

Balance conditions

The REIT must also satisfy the following conditions in relation to the balance of its activities between its tax-exempt property rental business and its other non-tax-exempt business.

Seventy-five per cent income test: at least 75 per cent of the REIT’s total gross income must accrue from its tax-exempt property-rental business;
Seventy-five per cent assets test: at the beginning of each accounting period, at least 75 per cent of the total value of the assets held by the REIT must be held for the tax-exempt property-rental business (ignoring liabilities secured against particular assets and determined in accordance with generally accepted accountancy principles (GAAP).

Groups

A group of companies can be entered into the REIT regime in the same manner as a single company. Offshore companies can be included in the REIT, but tax will be payable in the UK on dividends from such companies if they relate to income from non-UK properties.

Tax treatment of the REIT

The REIT will receive an exemption from corporation tax on any income or gains that arise from it in respect of its tax-exempt property-rental business.

The other non-tax-exempt business within the REIT will remain subject to corporation tax at the prevailing rate (currently 30 per cent).

Tax on investors

Distributions of profits from the tax-exempt property business are to be taxed in the hands of shareholders as if they were rental income (for example, UK corporate shareholders taxable at the rate of up to 30 per cent; UK resident individuals up to 40 per cent). The REIT will be required to withhold tax of 22 per cent from distributions to non-UK shareholders. In this way, investors are taxed on receipts from the REIT’s property-investment business and pay tax as if they had held a share in the properties directly.

Profits from the non-tax-exempt business, which have borne corporation tax can be paid without deduction of tax, and will be taxable as corporate dividends in the normal way.

The alternatives

As noted above, there are no UK investment vehicles that can be marketed to the public that offer optimum tax efficiency. It is the retail investor, the individual or trustee, who will benefit most from the introduction of the REIT. Retail investors may also benefit from changes that have been proposed to tax legislation for UK authorised funds such as authorised unit trusts. These changes could see FSA authorised non-UCITS (undertakings for the collective investment of transferable securities) retail schemes become viable onshore alternatives to a REIT.

Institutional investors and high-net-worth individuals already have other options that provide tax efficiency, such as offshore unit trusts, limited partnerships and authorised qualified investor schemes. It will be interesting to see the extent to which REITs can attract this market. In addition, these sophisticated investors also have the choice of the number of offshore legal vehicles that are being developed by the property-investment management industry. These provide tax-effective and limited-liability legal structure for investors wishing to invest in (predominantly) European real estate and a number of these are likely to offer alternative investment structure for such investment compared to the REIT. Two examples of these are outlined below – the Luxembourg FCP and the Guernsey closed-ended company.

The Luxembourg FCP

The Fonds Commun de Placement (FCP) is not a separate legal entity, but a contractual undertaking for collective investment. It is constituted by management regulations that will govern the way in which the Luxembourg domiciled management company will manage the fund.

Commonly, an FCP for real property investment will be limited to institutional investors. The FCP is subject to Luxembourg regulation. Investors will subscribe for interests in the FCP, which will have the investment characteristics of units in a collective investment scheme or limited partnership interest, and will provide for investors to have limited liability by reference to the amounts that they have agreed to subscribe.

The provisions of the management regulations relating to the draw down of investment commitments, profit sharing, management fees, carried interest redemptions, transfer and common investor protections in what is essentially a closed-ended fund, will be very similar to those encountered in a typical property-fund limited partnership in use for UK property investment. Exit may involve a listing of the interest in the FCP through incorporation of this contractual arrangement.

Guernsey closed-ended investment company

The shares in a closed-ended Guernsey investment company could be established for listing on the UK alternative investment market or on the full London Stock Exchange, usually when a given percentage of the fund has been subscribed (perhaps a minimum of 50 per cent).

The Guernsey investment company is a common vehicle for a corporate investment fund investing
in underlying European property. This vehicle can accommodate the following features common to
institutional investment vehicles in real property:

Draw down of investor commitments in instalments as and when property investment opportunities arise;
The conferral of different rights attaching to different classes of share, dependent perhaps on the size of the particular investor’s commitment;
Other features described above in relation to the FCP.

Once listed, this vehicle would also be available for retail distribution though would not be as tax efficient
as a UK REIT for, say, a UK individual.

Time will tell whether these and similar structures in other jurisdictions become real alternatives to the REIT, especially for institutional investment into property in Europe.

Tracy Fisher is a partner in the corporate tax department at DLA Piper. She can be contacted at tracy.fisher2@dlapiper.com