The property industry has for many years lobbied for a UK Real Estate Investment Trust. A recent discussion paper issued by the Treasury has generally been welcomed and has allayed fears that the Government’s approach would be too prescriptive. It focuses on a number of key issues that still need to be resolved.
Why are REITs in demand?
The REIT is designed to allow an investor to replicate the returns received through owning real estate directly. This is achieved by taxing the investors on the income received from the REIT and from the capital gains arising on a sale of their investment in the REIT; tax is not charged at the level of the REIT. Generally, commercial property is not an asset class that most individuals may invest in directly and, even for institutional investors, the illiquid nature of property and high transaction costs reduce its attractiveness.
Investment in a REIT allows the investor to diversify his risk and spread his investment between assets that will produce an income stream and those that will provide capital appreciation. One of the key aims of the Government is to increase the capital flow into the commercial property sector and it is thought that the REIT can help to achieve this.
For property companies, the REIT is seen as a potential antidote to shares trading at a discount to net asset value. In recent years, some property companies have resolved this issue by going private. It is thought that the principal valuation drivers of a REIT are likely to be dividend yield and the growth prospects for dividends per share. Some studies have suggested that a number of the existing listed property companies would start to trade at a premium to net asset value if they converted to a REIT. Some have warned, however, that the price will not behave like real estate but will be every bit as volatile as stock market prices.
How will the UK-REIT work?
A discussion paper issued by the Treasury makes it clear that a decision has been made about a number of the issues that were raised in its March 2004 consultation paper. The new vehicle will be named “UK-REIT” and be a closed ended corporate (in other words – unlike a unit trust or an OEIC – the options for exit are restricted in the same way as for other companies). The discussion paper indicates that the Government is still considering whether the UK-REIT should be required to list on a recognised investment exchange. It will be surprising if the Government does not make listing mandatory, given that one of its key aims is the provision of an accessible vehicle for retail investors wishing to tie returns to commercial property.
The Government appears to have dropped the idea of having a requirement that there should be a minimum number of shareholders. However, it may wish to monitor the concentration of shareholders to ensure that the UK-REIT is not used as a “private” vehicle; if it is listed, it will presumably be subject to the normal rule that at least 25% of the shares must be in public hands. It is understood that in some cases shares in SIICs (the French version of the REIT) are concentrated in the hands of a relatively small number of shareholders, although there seem to be signs of a move to wider share ownership (possibly to stave off government regulation in this area).
The UK-REIT will be able to invest in real estate located anywhere in the world. Any attempt by the Treasury to confine investment to UK property (which would have helped to further its aim of improving the quality of the property stock in the UK) would probably have been in breach of EU law (at least to the extent that it prohibited investment in property within the EU).
A single property vehicle will not be eligible for UK-REIT status, on the grounds of the additional risk that this may bring to the investor. Nevertheless, there is hope that the final-form rules will provide specifically for start-ups, so that UK-REIT status is available even though the vehicle may initially hold only one property. The basic premise of a REIT is, of course, that its activities are confined to real estate investment. Even so, it is accepted that, if UK-REIT status were available only where income was derived exclusively from property letting, it would make for a rather inflexible vehicle. Other countries that have adopted REITs all have rules that permit some level of ancillary income. The discussion paper suggests that the activities of the UK-REIT will be classified either as non-taxable (ring fenced property letting business) or taxable (non-ring fenced business).
Following representations, the Government has seemingly settled on a requirement that at least 75% of the total gross income of the UK-REIT should be derived from, and at least 75% of the gross value of the assets of the UK-REIT must relate to, the ring fenced property letting business. The precise demarcation of activities into ring fenced and non-ring fenced business is still open to discussion, but it seems that the boundaries will equate broadly to activities within a Schedule A property letting business and those outside. The 75% tests therefore offer a degree of flexibility. For example, a hotel company may be able to put in place a UK-REIT structure under which the REIT owns the hotels and lets the hotel real estate to a subsidiary company that owns the hotel businesses. UK-REITs will not, however, be permitted to invest in property derivatives.
The basic premise of a REIT is that most of its income will be distributed to investors. Generally, other countries where REITs are available require somewhere between 80% and 100% of the income of the REIT to be distributed. The proposal is that the UK-REIT will be required to make a distribution of at least 95% of its real estate investment income after “appropriate deductions and capital allowances”. One of the Government’s aims is to attract capital into property and as a consequence improve the quality of the UK’s property stock. An obligation to distribute the vast bulk of its income arguably detracts from the UK-REIT’s ability to spend money in improving the quality of the buildings. The Government line seems to be that retaining 5% of earnings should be enough to deal with routine expenditure on the fabric of the buildings, and if substantial work is required the UK-REIT should be required to raise further capital in the market.
It seems inevitable that the Government will impose a cap on the level of borrowings by UK-REITs, although its reason for this seems to have more to do with the potential loss of tax than any risk to investors. The proposed 95% distribution is after interest and therefore, if the Government does not put a cap on the level of borrowing, this would allow the UK-REIT to gear up and thereby reduce the distributions received by investors. This would in turn reduce the tax that the Government could collect. A cap on the level of borrowing helps the Government to ensure that investors receive an acceptable level of distribution and the Government receives an acceptable amount of tax. Other countries have caps: for example, Belgium, Italy and the Netherlands all have caps of around 50-60% of gross assets. It would not be surprising to see a similar figure in the final legislation.
Conversion charge
France wasted no time in legislating for the SIIC. One reason for this was that the French Government recognised the opportunity for a one-off tax charge that would be made on all companies converting into SIICs. Property companies may be carrying properties pregnant with capital gains, but the French Government would not see any tax without the disposal of these properties. Offering property companies the opportunity to convert to SIICs was tempered by a 16.5% exit tax on unrealised capital gains which, to sweeten things, is payable in instalments over four years. Property companies that had carry forward capital losses could also use these to set against the unrealised gains.
It is not surprising that the UK Government will also require a one-off tax charge on companies that convert to UK-REIT status. It is unclear whether this will be in the form of an exit charge on capital gains (similar to the SIIC model) or at a much lower percentage rate on gross assets. A tax on unrealised gains is likely to be a disincentive to convert to UK-REIT status for those companies carrying property with high unrealised gains. The alternative is a gross asset charge akin to stamp duty land tax. For the Government, the conversion charge represents additional revenue that is designed to compensate it for the perceived loss of revenue that will result from permitting investment in property through a UK-REIT. For those that are considering conversion, it is the price that must be paid to convert to UK-REIT status and obtain the benefits that go with it. It seems inevitable that, however the conversion charge is fixed, it will prove attractive for some and decidedly unattractive for others, who may decide to use UK-REITs only for start-ups.
Does the Government have an insoluble tax problem?
The basic premise is that the UK-REIT does not pay tax on its income or gains. Instead, the Government gets its tax through taxing the investor on income received from the UK-REIT and on capital gains that the investor makes on the sale of its shares in the UK-REIT. The requirement on the UK-REIT to distribute 95% of its income ensures that the investor has income upon which he is required to pay tax. A withholding tax of 22% will be levied on income distributions. It is clear from the discussion paper that the Government has a concern that it may be unable to collect the required amount of tax where some of the investors in the UK-REIT are non-UK resident. In the case of a distribution to a foreign investor resident in a country with which the UK has entered into a Double Taxation Agreement, it is likely that a reduced rate of withholding tax (no more than 15%) will apply. This will, of course, reduce the Government’s tax take.One alternative put forward by the Government is to tax the UK-REIT at 22%. But this does not seem to be an attractive solution, since, unless pension funds and other exempt investors are given a refundable tax credit, these types of investors simply would not invest. If the Government were to give a refundable tax credit it would also have to extend this to non-resident investors (at least those in the EU) of a similar type (for example, non-resident pension funds) in order to comply with EU law. That might result in an even greater loss of revenue.
It remains to be seen whether the UK Government will fall in line with other European Governments, such as the Netherlands, Italy, Belgium and France, which have all accepted that foreign investors may receive more favourable tax treatment than resident investors because of the reduced withholding tax under certain Double Taxation Agreements. In France, for example, there has been substantial investment by Spanish residents in SIICs because the rate of withholding tax under the relevant agreement is reduced to 0%.
When will the first UK- REIT arrive?
Although the Government is certainly enthusiastic about the UK-REIT it has not yet irrevocably committed itself to its introduction. Nevertheless, everyone expects the outstanding issues to be resolved to the satisfaction of the Government and for draft legislation to appear in the Chancellor’s Pre-Budget Report towards the end of this year. If this happens we can look forward to final legislation in next year’s Finance Act.
