There has been a significant increase in the amount of real estate held and traded through corporate and similar vehicles. Corporate law issues may sometimes appear to obscure the original rationale for what is essentially a real estate transaction. But these issues cannot simply be ignored.
The corporatisation of real estate
The trend over recent years to use corporate vehicles has been driven by the increasing number of investors looking to invest in real estate. Many of these investors lack the scale or inclination to buy directly into real estate, and prefer to invest through managed funds. With the comparative tax disadvantages of UK quoted property companies, such as British Land and Land Securities, a number of other types of vehicles for property ownership have become popular.
Another major factor is stamp duty land tax, which is now at 4% for all transactions over £500,000. The impetus to find ways of trading property without incurring SDLT – typically through the sale of shares or units in a vehicle that owns the underlying land and buildings – led at first to the increasing use of limited partnerships, until changes to SDLT made these less attractive. Now offshore unit trusts have replaced them (at least for the time being) as the typical non-corporate vehicle for ownership of UK real estate.
Typical issues
These property ownership structures can give rise to a number of issues, including:
- tax – besides ensuring that the SDLT treatment of any transaction is as expected, the structure will need to take account of the taxation of income and capital gains. A UK-resident company will pay corporation tax on income and gains. Where overseas entities are involved, residence questions may arise. For example, in the context of European investment structures, it has become common to locate vehicles in Luxembourg, but other countries may test the substance of the Luxembourg vehicle before allowing it to benefit under the applicable double tax treaty. In the UK, HM Revenue and Customs may challenge the offshore residence of the vehicle by arguing that it is managed and controlled in the UK.
- regulation – some of the vehicles commonly used – particularly limited partnerships, unit trusts and limited liability partnerships – may constitute collective investment schemes for the purposes of the Financial Services and Markets Act 2000 (FSMA). Under FSMA, only persons who are authorised by the Financial Services Authority can establish or operate a collective investment scheme. In some cases it may be possible to avoid these requirements, either through establishing the vehicle overseas (in a jurisdiction with less onerous regulatory requirements) or by taking advantage of one of a limited number of exemptions afforded by FSMA. On the other hand, it has become common for property companies and agents to establish FSA-regulated subsidiaries, in order to ensure that they can participate fully in all types of transaction.
- governance – where vehicles are co-owned, the extent of the control vested in each owner will always need to be addressed. Even where a vehicle is wholly-owned, compliance with tax-driven requirements – such as offshore management and control – will give rise to governance issues in practice.
- warranties and indemnities – on a conventional acquisition of property, little attention is usually paid to warranties and indemnities, because the buyer is generally assured of obtaining good title through the registration process. Where property is acquired indirectly through the purchase of a vehicle, there are risks as to title (does the vehicle actually own the property?) and as to contingent liabilities (does the vehicle have any undisclosed liabilities? What else has it done?). This makes warranties and indemnities critical, with the intention usually being to put the buyer as far as possible in the same position as if it was buying the property directly.
Offshore companies
Offshore companies (in this context, often referred to as special purpose vehicles or SPVs) offer a number of benefits in relation to ownership of UK real estate. Normally there will be no stamp duty on transfers of shares and, if managed and controlled offshore, the company will pay no UK tax on capital gains. The use of leverage can substantially reduce the amount of tax payable on rental income, and profits can usually be distributed to shareholders without taxation in the offshore jurisdiction and free from withholding tax.
SPVs are not suitable for all UK-based investors, due to the UK’s “controlled foreign company” and other anti-avoidance rules. Many UK property investors are tax exempt (notably UK pension funds and charities), and for them offshore companies will inevitably give rise to some tax leakage. For others, using an offshore company as a vehicle for holding UK real estate will not give rise to additional tax liabilities, and offers the prospect of a subsequent sale free from SDLT – with the resulting 4% saving available for sharing between the seller and the purchaser.
Some difficulties do arise with the transfer of property into and out of the SPV. There is unlikely to be any exemption from SDLT on the transfer to the SPV, unless group relief is available (where the transferor and the transferee are part of the same corporate group). If so, no SDLT is payable at the time of transfer to the SPV, but clawback rules provide for the SDLT to be recovered if the SPV leaves the transferor’s group within three years and group relief is also now the subject of a general anti-avoidance rule, which has restricted its use in this context.
If the purchaser does not wish to retain the SPV (for example, because it is a pension fund), it should be able to liquidate the company and obtain direct ownership of the property without SDLT arising, as there is an exemption from SDLT where property is transferred by way of a distribution in liquidation. A liquidation will, however, constitute a disposal for UK tax on capital gains, so it is important to ensure that the offshore company continues to be managed and controlled offshore.
Selling the SPV
The purchaser of an SPV will be concerned about contingent liabilities, over and above the liabilities directly related to the real estate that the purchaser expects to assume on acquiring the property. Although the purchaser can try to cover contingent liabilities through warranties and indemnities, there may be a number of practical difficulties. Perhaps there is concern, for example, as to the covenant strength of the seller, which is often an SPV itself. The purchaser may need to insist on some form of escrow or retention in order to feel adequately protected.
There may also be difficulties in relation to time periods for the warranties and indemnities, and the aggregate cap on liability. The seller will be looking to keep the time period as short as possible (often because it is itself a fund or SPV that wishes to return the proceeds to its investors and wind itself up). In terms of liability cap, whereas a cap equal to the amount of the consideration is common in normal M&A transactions, this is harder to justify with a true SPV, where there should be few contingent liabilities and substantially all of the value is in the real estate. But the analysis may be complicated for a number of reasons: there may be a risk (albeit a low risk) of significant liabilities – for example, potential UK tax on capital gains, or concerns over the validity of the SPV’s title to the property. If the SPV has significant external debts, the share price will be significantly less than the value of the property: there is then the question of whether a cap fixed by reference to the share price affords sufficient comfort in view of the type of risks that have been identified.
Given that it is a corporate entity, the SPV will have its own assets and liabilities besides the property – for example, cash, receivables and payables. The purchase price will usually be based on an agreed value for the property, but this will usually be adjusted to reflect these additional assets and liabilities. The purchaser may wish to insist on the preparation of completion accounts following completion of the acquisition, to ensure that these have been accurately assessed. If reliable financial information is available, it should be possible to predict the likely position at completion with considerable accuracy, so that minimal post-completion adjustment is needed.
Offshore unit trust
Offshore unit trusts – usually established in Jersey or Guernsey – have become common since the introduction of the recent SDLT changes, particularly those that affected limited partnerships. A considerable number of limited partnerships have effectively converted to unit trust status, so that investors can sell their participations without SDLT. This is because the transfer of units in a Jersey or Guernsey unit trust is free from UK stamp duty and SDLT, whereas the transfer of limited partnership interests is now subject to SDLT on the value of the underlying real estate.
An offshore unit trust involves one or two trustees executing a trust instrument, pursuant to which units are issued to investors (called unit holders). The trustees hold the assets of the trust, which may constitute title to real estate held directly, or interests in intermediate vehicles that hold underlying real estate, or both. The trustees will act on advice or instructions. Typically there will be a Jersey-based manager for the trust, who gives instructions to the trustees reflecting advice received from a UK-based property adviser.
The current advantage of these unit trusts is that, on establishment of the trust, real estate can be transferred to the trust by the seller in exchange for units free from SDLT (so-called “seeding relief”), and units can be sold free from stamp duty and SDLT.
This offers a purchaser willing to acquire property via a unit trust the opportunity (through a two-stage process) to make the acquisition without incurring SDLT.
Some of the issues arising with the establishment and operation of a unit trust are that:
- a unit trust will be exempt from UK tax on capital gains only if it is managed and controlled offshore. It is therefore critical, as with an offshore company, that important decisions are taken by the manager or trustees, and not by UK-based advisers.
- there are strict conditions that must be met if seeding relief is to be available. In particular, the transferor must not receive any consideration other than units. This can cause difficulty, because it normally requires a secured lender to release its mortgage when the property is contributed to the trust.
- transfer of the property to the trust will often trigger a disposal for tax purposes, resulting in the crystallisation of a tax liability at a point where there is no certainty that the units will be sold.
- a unit trust will be a collective investment scheme, but if it is established offshore the UK rules are not relevant in practice. The requirements of the Jersey and Guernsey authorities are easier to comply with.
Limited liability partnerships
LLPs were introduced in the UK in 2001, and have not been widely used as vehicles for ownership of UK property.
An LLP is a separate legal entity but in principle it has tax transparency for the members. The problem is that the Government, concerned that tax transparency might be open to abuse, introduced a special provision to the effect that LLPs are not tax transparent for certain types of property investor (notably pension funds and other tax exempt investors). This means that an LLP can be used by some categories of investor – offshore persons, UK property companies, private individuals – but not all.
An LLP can be useful, however, where the activity involves trading rather than investment – for example, where a property is being developed for subsequent sale. Some of the salient features to be considered in this context are that:
- an LLP permits great flexibility in terms of sharing of profits, and also governance. This is useful in the context of joint ventures.
- an LLP can constitute a collective investment scheme, although an exemption will be available if all members participate in the day- to-day management of the business. This makes an LLP particularly suitable for a joint venture with a small number of participants.
- an LLP does not offer any special SDLT benefits, so it is unusual to effect an exit by means of a sale of the LLP (as opposed to the property itself).
The pre-Budget report may have an impact on the choice of property ownership structure. We shall report any significant developments on our free on-line information service, at www.law-now.com.
